which was not only done excellently but also quickly (because I didn’t give him much notice) .Acknowledgments
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his book was launched in a meeting with Doug French and Jeff tucker of the Mises Institute . Finally. I consulted with Zachariah Crossen. At every step in its writing.
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. a history teacher who ran the sample chapters by his own (junior high) students to make sure the tone and language were correct .
Brian shelley and Blake stephenson provided useful feedback on an early draft . I’d like to thank sam torode for the artwork. tim terrell went through the entire manuscript and provided many suggestions to improve it .

Part I

FOUNDATIONS

Lesson 1

Thinking Like an Economist

In this lesson you will learn:
• What it means to “think like an economist.” • The types of questions that economics can help explain. • Why it is important for everyone to understand basic economics.

Thinking Like an Economist
his book is a manual for a new way of looking at the world . After you master the lessons contained within these pages, you will be able to understand events in ways that your untrained peers will miss . You will notice patterns that they will overlook . the ability to think like an economist is a crucial component of your education . Only with sound economic thinking will you be able to make sense of how the world works . to make responsible decisions regarding grand political ideas as well as your occupation and mundane household finances, you must first decide to learn basic economics . Creative and careful thinkers throughout human history have developed various disciplines for studying the world . each discipline (or subject) offers its own perspective as history unfolds before us . For a complete education, the student must become acquainted with some of the most

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important findings in each field . economics has proven itself to be worthy of universal study . A well-rounded young adult will have studied not only algebra, Dante, and photosynthesis, but will also be able to explain why prices rise . every subject you study will contain a mixture of knowledge that is deemed important for its own sake, as well as practical applications that may prove useful in your daily life . For example, every student should have a basic understanding of astronomy, since it illustrates the grandeur of the universe; but basic astronomy can also come in handy when guiding a wayward yachtsman who has lost sight of land . For a different example, consider mathematics . the study of advanced calculus is rewarding for its sheer elegance (though some students might consider the reward inadequate for the effort required!) . But everyone needs to know basic arithmetic in order to function in society . We will see the same pattern holds in the subject of economics . It is, in a word, simply fascinating to learn that there are underlying principles or “laws” that explain the operation of any economy, whether in ancient Rome, the soviet union, or a county fair in Boise, Idaho . Yet economics also has much to offer in practical guidance of your daily life . Knowledge of economics, by itself, will not make you rich, but it’s a good bet that ignoring the lessons of this book will keep you poor . economists look at the world in a unique way . Picture the crowds waiting to ride a popular amusement park roller coaster . A biologist surveying the scene might notice that people begin sweating as they approach their turn to get onto the ride . A physicist might notice that the first hill has to be the tallest . A sociologist might notice that the riders are arranged in groups of the same ethnicity . And an economist might notice that the first and last cars have much longer lines than the others, probably because people don’t like waiting but they also prefer riding in the very front or the very rear . the economic perspective is not useful in every situation . On the soccer field or at the prom, the lessons in this book will not prove as relevant . But in your life you will encounter many situations of critical importance when your decisions will need to be informed by sound economics . It is not necessary for everyone to become an economist . It is important for everyone to learn how to think like an economist .

Lesson 1: Thinking Like an Economist

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Is Economics a Science?
In this book, we adopt the view that economics constitutes an independent science, just as surely as chemistry and biology are distinct fields of study . As we go through the lessons in this book, we will do so scientifically, meaning that we will use an objective set of “tools” for our analysis, that do not rely on particular ethical or cultural assumptions . the principles or laws of economics are the same, whether the economist is a Republican or a communist, and whether he lives in new Zealand or somalia . Warning! When we say economics is a science, we do not mean that we conduct experiments to test economic laws, the way a nuclear physicist studies the results of smashing atoms in a particle accelerator . there are important differences between a social science such as economics, versus a natural science such as physics . We will explain this in more detail in Lesson 2, but for now we simply want to caution you that basic economic principles can be discovered through mental reasoning . It wouldn’t make sense to go out and “test” the laws of economics, just as it doesn’t make sense to use a ruler to go out and “test” the various proofs that you might learn in a geometry class . the upshot of all this is that the lessons in this book will stand the test of time—there is no danger that a new experimental finding will overturn them tomorrow . In practice, professional economists make all sorts of conjectures, many of which turn out to be wrong . But the core body of economic theory—the types of laws and concepts contained in this book—is not testable; it’s simply a way of viewing the world . Despite the possible confusion of economic science with a natural science, nonetheless we use the term science because it’s important to stress that there really are objective laws of economics . When politicians ignore the teachings of economics, their programs run into disaster—imagine the chaos if nAsA ignored the laws of physics!

The Scope and Boundaries of Economic Science
It’s a common misconception for people to think, “economics is the study of money .” Yes, economics obviously has a lot to say about money, and in fact one of the basic purposes of economics is to explain the different

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prices—which are quoted in units of money—of various goods and services being sold in the market place . Contrary to this popular misconception, economics is broader than the mere study of money . In its widest scope, economics can be defined as the study of exchanges . this would include all of the exchanges in a normal market setting, where the seller hands over a physical object or provides a service, and in return the buyer hands over the appropriate amount of money . But economics also studies cases of barter, where the traders exchange goods or services directly with each other, without using money at all . Pushing it to the extreme, economics even has a lot to say about cases where a single, isolated person takes actions to improve his or her situation . this is often called “Crusoe economics,” after the fictional character Robinson Crusoe who was shipwrecked on an (apparently) deserted island . We will study Crusoe economics in Lesson 4 . It will be clear that even an isolated person behaves “economically” because he takes what nature has given him and exchanges the status quo for an environment that he hopes will be more pleasant . the common theme running throughout all of the examples of exchanges is the concept of scarcity . scarcity can be succinctly explained by the observation that there are limited resources and unlimited desires . even Bill Gates faces tradeoffs; he cannot literally do whatever he wants . If he takes his wife out to a fancy restaurant, he has reduced his options (ever so slightly) and has diminished his ability to buy other things in the future . We can describe the situation by saying, “Bill Gates needs to economize on his resources, because they are finite .” It is the universal fact of scarcity that gives rise to what people have termed the “economic problem”: As a society, how should we decide which goods and services to produce, with the limited resources at our disposal? In Lesson 5, we will see how the institution of private property solves this problem . But it is scarcity that causes the problem in the first place . Warning! economics does not study a hypothetical “economic man,” who cares only about acquiring material possessions or earning money . this is another common misunderstanding of what economics is all about . unfortunately, there is some truth to this stereotype because many economists actually do build models of the economy that are filled with fictitious people who are very selfish and will only act altruistically if they are forced

Lesson 1: Thinking Like an Economist

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to do so . But in this book, you will not be learning any theories of that flavor . Instead, the lessons in this book do not depend on people being pennypinchers; the laws we will develop in these pages apply to Mother teresa as much as they apply to Donald trump . economic science, as taught in this book, does not tell workers that they should take whatever job pays the most money, nor does it tell business owners that they must consider only financial issues when running their operations . these points will be made clearer during the subsequent lessons themselves, but we must stress up front that there is no “economic man” in the following pages; we are always discussing the principles that explain the choices of real people in the face of scarcity . the principles involve the fact that people have desires in the face of limited resources, but the principles are broad enough to cover people with any desires .

The Economics of Real People
Economics deals with the real actions of real men. Its [laws] refer neither to ideal nor to perfect men, neither to the phantom of a fabulous economic man (homo oeconomicus) nor to the statistical notion of an average man. . . . Man with all his weaknesses and limitations, every man as he lives and acts, is the subject matter of [economics]. —Ludwig von Mises, Human Action (Auburn, Ala.: Ludwig von Mises Institute, 1998), pp. 646–47

economics studies and tries to explain how people make exchanges . A shipwrecked sailor wants to “exchange” some sticks and two rocks for a crackling fire, while a missionary wants to “exchange” his leisure time for a grueling trip to a remote jungle where the residents have never seen a Bible . A complete theory of exchanges must cover these types of cases too, not just the more familiar example of a broker exchanging 100 stock shares for $2,000 .

it should take your breath away . When you stop and think about what happens every day in a modern economy. For an analogy. day in and day out . they will give you a framework to help analyze your plans so that you are more likely to achieve your objectives . Of course. the basic truths
. the lessons in this book will not by themselves make you rich . financial services. designing four-lane bridges . Beyond its intrinsic beauty and practical applications to your own life. economics is a crucial topic because we live in a society plagued by an activist government . to feed these hordes . it is a wonder that its operation is normally so flawless that we take it for granted . Consider the bustling metropolis of Manhattan: Millions of people work on this tiny island that is less than 23 square miles in land area . At first some readers may not understand this claim—some of the finest restaurants in the world are in Manhattan! But these exquisite restaurants rely on vendors to give them the raw materials to produce their very expensive dishes .8
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Lessons for the Young Economist
Why Study Economics?
One reason to study economics is that it’s simply interesting . unlike other scientific disciplines. But nobody would want to drive on a bridge designed by someone who is ignorant of geometry . Rather. but actually to thrive . the workers on the tiny island of Manhattan transform the materials at their disposal into some of the most highly valued goods and services on the planet—think of the expensive jewelry. and other items are shipped into Manhattan on a daily basis. Obviously there is not enough food produced on the island itself. When you consider the incredible complexity of these processes. legal work. within two months hundreds of thousands of new Yorkers would be dead from starvation . studying geometry alone will not allow you to become a professional engineer. clothing. refined gasoline. the lessons in this book will shed some light on how the market economy achieves such feats. allowing the inhabitants to not only eke out a bare survival. Another reason to study economics is that it will help you make decisions in your personal and professional life . and Broadway performances “produced” in Manhattan . Yet in the real world—where no Martian bubble obstructs trade—farm produce. If invading Martians placed an impenetrable plastic bubble around Manhattan (with small holes in the plastic to allow for ventilation).

It really doesn’t matter if the man on the street thinks quantum mechanics is a hoax. or that low interest rates cure a recession. For this reason. the lessons in this book will show you how .Lesson 1: Thinking Like an Economist
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of economics must be taught to enough people in order to preserve society itself . But if most people believe that minimum wage laws help the poor.
. the physicists can go on with their research without the approval of the average Joe . then the trained economists are helpless to avert the damage that these policies will inflict on society . it is the young adult’s duty to learn basic economics .

• Economics is the study of exchanges. etc. In a modern economy.10
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Lesson Recap •••
• This book will teach you to think like an economist. Some perspectives are more useful in certain situations than others. and it has important insights on how the social world works. Economics is a distinct field. Different subjects (chemistry. or science. • Every citizen should understand basic economics because of the danger of destructive government policies that ignore the lessons in this book. biology. but economic principles apply to any type of exchange.) offer different perspectives on the world. the most familiar exchanges involve money.
.

rather than using money in an intermediary transaction .Lesson 1: Thinking Like an Economist
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new Terms
Barter: A situation where people exchange goods and services directly. scarcity is a universal fact requiring people to make exchanges . Tradeoffs: the unfortunate fact (caused by scarcity) that making one choice means that other choices become unavailable . Scarcity: the condition of desires exceeding the available resources to satisfy them .
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sTudy QuesTions
1. Does scarcity affect everyone? 4. *Isn’t it just as important for the average person to understand particle physics. Do the laws of economics still work inside a maximum security prison? 5.
. **More challenging material . Is economics a science? Why or why not? 3. Can economics make you rich? 2. since much of the funding for this research comes from government grants?
*Difficult material .

• The difference between a social science and a natural science. We don’t say that the baseball “wants to move in a parabola. we might mention things like mass.Lesson 2
How We Develop Economic Principles
In this lesson you will learn:
• The difference between a purposeful action versus mindless behavior. one of the most basic and crucial distinctions we all make—usually without even realizing it—is the difference between purposeful action versus mindless behavior . When describing the trajectory of a baseball. we are describing the motions of a jet aircraft .” this would be nonsense talk to modern ears. we would have no problem saying that the pilot “wants to avoid the turbulence” or that he “is running low on fuel and decides to land .”
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. In that case. velocity. But suppose that instead of a baseball. and would strike us as very unscientific . • Why the methods used to develop basic economics are different from those used in physics or chemistry. and air friction .” or that the ball “gets bored with flying and eventually decides to land .
Purposeful Action versus Mindless Behavior
hen we look at the world and try to make some sense of it.

we can either attribute them to natural laws. too . When we observe events.” then we would interpret your subsequent behavior as an intentional response. and obviously we are not going to give you “the final word” in this short lesson . For example. economics always involves the operation of at least one mind. meaning an intelligence that has conscious goals and will take steps to influence the material world in order to achieve those goals . In short. As we will see in Lesson 3. we can choose whether to believe that another mind is at work . we need to be aware of the distinction between purposeful action versus mindless behavior . It’s true. Although your nervous system and brain were involved. because he wants his team to win the game . we wouldn’t really say that your mind was involved . not to the latter . But if your doctor whacks your right knee with a hammer to test your reflexes. sometimes the boundary line between what is “conscious action” and “reflexive behavior” can be blurry. We are here touching on some very deep philosophical questions. the difference between purposeful action versus mindless behavior is not simply the difference between human beings and “inanimate” matter . to give it a solid foundation. a baseball outfielder might not be fully aware of the mental operations he performs when throwing the ball to second base . the resulting movement in your leg would not be an example of purposeful action . or we can explain them (at least in part) by reference to the intentions of a conscious being .
. Various movements of a human being’s physical body can be examples of mindless behavior. “I’ll give you $20 if you raise your right leg. but that won’t really detract from the principles in this book . But he is very definitely trying to throw out the runner.14
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Lessons for the Young Economist
this difference in how we describe the two events reflects a fundamental decision we make when interpreting the world around us .) the lessons in this book apply to purposeful actions performed by conscious people who have goals in mind . the laws of economics apply to the former. and that difference is crucial to this lesson . if I tell you. (note that brain and mind are very different things. where you purposely moved your leg because you wanted the money . But in order to make sense of economic theory.

with the notable exception of biology. astronomy. But in order for the sociologist to even collect data to test this theory.” the lessons in these pages apply to real people who use their minds to make exchanges in the real world every day . influencing events .
The Social versus the Natural Sciences
economics is a “social science.” meaning that it studies people and aspects of society .Lesson 2: How We Develop Economic Principles
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even if he “miscalculates” and overthrows the base. the social sciences focus on purposeful action. a sociologist might come up with a theory relating an increase in the crime rate with the increase in the rate of divorce . It’s not confined to the formation of theories to explain events. on the other hand. the natural sciences include physics. and meteorology . the social scientist’s explanations and theories at least implicitly rely on the hypothesis that there are other minds at work. the economic principles in this book are not confined to “perfectly rational people . all the lessons in this book apply to his intentional action. and not purely natural or physical . while the natural sciences focus on mindless behavior . For example.
. the natural sciences. study aspects of the natural world . biology. and anthropology . these are not mere brute facts of nature . In sharp contrast. because he is a conscious being trying to exchange one situation for a different one that he thinks will be more desirable . the natural scientist typically doesn’t refer to a conscious intelligence when explaining events in his field of expertise . Because of their different subject matter. she needs to “get inside other people’s minds” in order to know which events should be classified as crimes and divorces in the first place. chemistry. sociology. Other social sciences include psychology. this awareness of other minds. as described in the preceding section. and the fact that other thinking humans have their individual motivations. pervades the social sciences . even though he might not even be aware that he is doing it. either: even the raw “facts” of the social sciences are themselves mental things.

notice that ultimately it is sally’s mind that makes the difference. pp. . if sally runs her car over Joe and he dies. because there is no single physical property which any one member of a class must possess. to stress the point one last time: nothing physical changes in the composition of the car during this transformation. . . the physicist and chemist wouldn’t notice anything happening to the molecules forming the car . These objects cannot even be defined in physical terms. . when we say that sally “turned the vehicle into a murder weapon. but rather just an accident . medicine. the sociologist needs to make guesses about what Sally consciously intended in order to know if a crime occurred . On the other hand. food. sentences. weapons. this may or may not count as a homicide . [T]hey can be defined only by indicating relations between three terms: a purpose. . “that’s the last time you’ll cheat on me!” then it’s time to read sally her rights . it was probably not a crime. —Friedrich A. 1948). 59–60
For example. . . except insofar as the description sheds light on what Sally was thinking when the car struck Joe . words. Hayek. no amount of physical description per se can decide the matter. On the contrary. If sally had a heart attack five seconds before the crash. It is easily seen that all these concepts . refer not to some objective properties possessed by the things. somebody who holds that purpose. I believe these to be fair samples of the kind of objects of human activity which constantly occur in the social sciences.” we are rendering a judgment
. and an object which that person thinks to be a suitable means for that purpose. if the cops arrive at the scene to hear sally yelling. communications. or which the observer can find out about them.16
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Even the “Facts” of the Social Sciences Are Related to the Mind
Take such things as tools. but to views which some other person holds about the things. Her mental will has the power to transform a regular car into a murder weapon . Individualism and Economic Order (Chicago: University of Chicago Press. . and acts of production.

Yet in another sharp contrast. typically in the natural sciences neither the raw facts. Generally speaking. One possible answer is that the social sciences have justified some pretty awful things. the physicists Richard Feynman and stephen Hawking have also captured the popular imagination . People refer to the former as “hard” and the latter as “soft.
The Success of the Natural Sciences versus the Social Sciences
there is a sharp difference between sciences such as physics. directly unobservable state of sally’s mind . where public opinion revered the scientists who studied people and not mindless particles . the smartest and most celebrated scientists in the world are found in the hard sciences.” and—especially among the hard scientists!—there is a general feeling that the so-called hard sciences are more rigorous and indeed “scientific” than the so-called soft sciences . In contrast. sociology. it is her conscious intentions that determine whether we need to add one more homicide to the running total . In contrast. many people are skeptical and even hostile to some of the social sciences. besides the obvious icon of einstein. and anthropology on the other . even the “raw facts” of the social sciences are tinged with our understanding of other people’s minds . and few people could even name the top sociologists of the last century . and biology on the one hand. As the example of sally hitting Joe with her car illustrates. What is going on here? If we hadn’t known the answer already. it is not nearly as prestigious to win awards in psychology.Lesson 2: How We Develop Economic Principles
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concerning the intangible. the physical movements of sally’s hands and feet as she controlled the car are not the crucial issue. we might have expected things to be the reverse. rely on an appreciation of the intentions of other thinking beings . particularly economics and psychiatry . such as electroshock therapy for people incarcerated against
. nor the theories developed to explain them. the natural scientist can look out upon the physical world and try to come up with explanations of its “mindless” behavior . chemistry. versus sciences such as psychology. While some people might condemn the particular physicists who helped create atomic weapons. even so the overwhelming majority support physics itself .

Physical theories make predictions about objects in the material world . until sigmund Freud. Consequently. It would be very difficult
. But again. why don’t people also tend to blame physicists for Hiroshima. Many people would agree that “psychiatry was doing all right . this is why it’s much less likely that physics will go down a cul-de-sac the way many people think Freudian psychology or Keynesian economics did . the physicists said to the military. versus the mediocre results and hostility to the social sciences on the other.” Many of the supposedly top-notch economists too told governments during the 20th and 21st centuries: “Give us control of the printing press. and yield a society with adjusted people who do not exhibit aberrant.” or that. so maybe these types of episodes are the reason many people distrust psychiatrists and economists . and allow us to inject them with drugs and perform other experiments on them . the track record of the psychiatrists and most influential economists is not nearly as laudable as that of the natural scientists . “Isaac newton did a lot of great work in physics. is that the objects of study in the natural sciences are fairly simple. In sharp contrast. anti-social behavior . or the chemists for gunpowder? We suggest the reason is that the physics and chemistry behind powerful weapons are right . until that nutjob einstein came along and ruined it . . “economics took a major wrong turn when John Maynard Keynes came on the scene . and the government-sponsored slaughter of millions of pigs during the Great Depression while Americans starved . the psychiatrists told the courts.” Obviously.” And the physicists were perfectly accurate in their predictions .” Yet almost nobody would say. “Give us authority to imprison people we think are mentally ill. it will induce a fission reaction that will release an incredible amount of heat . “If you drop this object from an airplane. and we will spare the world any more ravaging depressions and rampant price inflation . it seems that even the most accomplished geniuses in the social sciences can lead their disciplines down dead-ends. For some reason.” One important reason for this gulf between the success and prestige of the natural sciences on the one hand.18
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their will. where more and more of the experts in the field (as well as the general public) begin to suspect that the “state of the art” is a waste of time . . the hard sciences can (typically) rely on controlled experiments to evaluate their theories . this will make them well. and their behavior seems to be governed by a concise set of rules .

even so. because its inferiority would be demonstrated repeatedly in experiments . but no physicist (including him) could argue with the accuracy of the theory’s predictions about experimental measurements made on subatomic particles . However. the problem is that. quite literally. After conducting an experiment using a clever new technique. with greater and greater precision and accuracy. one group in Australia announces that the previous estimate needs to be revised . It has proved fiendishly difficult to come up with a set of concise laws that accurately predict the behavior of people in various circumstances . the rival group of physicists argues that the Australian experiment is flawed. things are not so simple in day-to-day physics . Most professionals in the social sciences think that the same method— the “scientific method”—should be used in their fields as well . the crucial assumptions behind
. the objects of their study have minds of their own . One theory may yield better predictions in a few experiments. In the social sciences. first suppose two groups of physicists are arguing about the strength of the electric charge on a certain particle . some physicists may “believe in” the more elegant theory. in order to understand their behavior—in order to “explain” subatomic particles—a theory in physics can’t be asked to do anything more than to predict. because the laboratory’s proximity to the south Pole distorted the measurements . since subatomic particles don’t (as far as we know) have minds. what these particles will do in various circumstances . to see if the measured results move closer to the previous estimate as the laboratory gets closer to the equator . However. and search for possible flaws in the experiments that cast doubts on their preferred theory . they settle the dispute by conducting the same experiment at several different latitudes. to illustrate this important difference between the natural sciences and economics. especially economics. now we should point out that in actual practice. in the long run a theory in the hard sciences that systematically and unambiguously yields better predictions will eventually displace its rivals .Lesson 2: How We Develop Economic Principles
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for a newfangled yet ultimately inferior theory to sweep the profession in a hard science (such as physics). einstein famously resisted some of the philosophical implications of quantum theory. while another theory may be simpler and more elegant . things are so much more complicated that in many cases it is simply impossible to perform a truly controlled experiment .

.” and that President Herbert Hoover and then Franklin D . say. the government “obviously” didn’t borrow and spend enough. A different group of economists—the Austrians—disagree strongly. Hoover and Roosevelt made the Depression drag on for more than a decade with their misguided interventionist policies . federal budget deficit in 1932. one group of economists— the Keynesians—believe that the Great Depression was caused by a collapse in “aggregate demand. and that the experimenters can hold every other (relevant) factor constant while isolating the effects of the magnetic charge emanating from the earth’s poles . Roosevelt should have pushed through massive government deficits—spending borrowed money—to counteract the slump . the Austrians dispute the Keynesian deficit theory. At this early stage of the book. things are not nearly as straightforward when two groups of economists argue over rival theories . there really is good reason to suppose that over the years. pointing out that Hoover and FDR ran what were at the time record high (peacetime) budget deficits during their administrations. central bank established by the government . economists can’t test the Keynesian theory by. you will learn the tools you need to better appreciate the two sides of the argument . which is the u . For example.s . as proved by the lingering unemployment . economic history .s .) For now. we have not yet mastered the concepts to proceed further with this actual dispute . which coincided with the slowest and most agonizing recovery in u . the physicists will develop theories with greater and greater accuracy in predicting how the physical world works . the Keynesians counter that. the point is that the dispute remains unresolved. (In subsequent lessons.s . According to the Austrians. large as the deficits were. because the exact conditions of the world economy in the late 1920s were unique . holding everything else constant except doubling the u . even though professional economists have been arguing about the causes of the Great Depression for more than seventy years . the story we just told gives an idea of why physics seems to “work” so well. in order to observe the effect on the unemployment rate . and instead think that the initial crash in 1929 was caused by a preceding “boom” engineered by the Federal Reserve. the controversy won’t die.20
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all of this research are that the underlying laws governing the particles are the same.

will tend to subscribe to the Keynesian arguments about the causes of the Great Depression .: Regnery.0 1933 4 .1 1939 3 . php) and the Bureau of Labor statistics
Economists Can’t Agree on the Right Medicine
[T]he proper injunction to government in a depression is cut the budget and leave the economy strictly alone. writing in 1932 Quoted in Robert P. – Austrian School economist Murray Rothbard Just as we saved our way into depression. 2009). pp.ucsb .2
sources: the American Presidency Project (http://www . for moral or political reasons.9
21 .8% 1931 0 .9
23 .0
14 .7
20 . – Business Week economist Virgil Jordan.9%
15 . 52. The Politically Incorrect Guide to the Great Depression and the New Deal (Washington.5 1938 0 .edu/data/budget .0
17 .57
It is no doubt true that economists who.6 1932 4 .2
(surplus)
8 . D.
.6
24 . endorse larger government spending.C. Unemployment.presidency . 1930 – 1939
1930 Budget Deficit (% of GDP) Unemployment Rate -0 .5 1934 5 . It is also true that opponents of “Big Government” will tend to be attracted to economic doctrines that stress the benefits of low taxation and slim government budgets .3
19 .1
17 .Lesson 2: How We Develop Economic Principles
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Federal Budget Deficits vs.0 1936 5 . Murphy.5 1937 2 . we must squander our way out of it.9 1935 4 .

the economist can more easily understand the motivations and constraints faced by other actors in the economy . Because he has an insider’s view of acting in the economy. the economist does have one enormous advantage over the natural scientist: the economic theorist is himself a thinking being.” and so the physicist must rely exclusively on the familiar empirical techniques to gain insight into the behavior of quarks . with conscious goals . with both camps firmly convinced that they are right and their opponents are either dishonest or sloppy . these passions are on a much tighter leash in the hard natural sciences. the lessons in this book will not appeal to experimental or even historical results to prove their validity . relying on techniques that are not available to the physicist or chemist . all is not lost . the particle physicist doesn’t have any idea “what it’s like to be a quark. In contrast. because in those disciplines the facts “speak for themselves” to a much greater degree than in the social sciences . these differences partly explain why the so-called hard sciences enjoy a much better reputation for objectivity and success than the soft sciences. including economics . You may decide that the concepts are more or less useful to you. you will gradually develop a new framework for interpreting the world . they will be yours forever .
How We Develop Basic Economics
As we discussed above. How is this possible? We explain in the next section . As you master the lessons in this book. Once you have grasped the essential points of each lesson. And as you will see.22
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But it is the inability to perform controlled experiments that allows the persistence of such diametrically opposed economic theories. there are other ways of discovering economic principles or laws. but you will never need worry that newly published economic research will render them false . economic theorists face two huge problems: the objects of their study have minds of their own and it is much harder to perform a controlled experiment in economics than in a natural science such as chemistry . Fortunately.
. However. even though the methods of the natural sciences are of limited use in economics. things that seemed incoherent before will make perfect sense to you .

we can use them to start building “theorems. we define what we mean by a point and a line. fifth line that divides the rectangle into two identical triangles . because you should first understand exactly what it is you’ll be doing as you work through Lesson 3 . As we go through the lessons. and subsequent.. You will probably be surprised in Lesson 3 when we show just how much of economics is packed into the simple observation that. we will continue to add new
. if we as social scientists decide to commit to the “theory” that there are other minds operating in the world—just as each of us can directly experience his or her own mental awareness—then that “theory” starts spitting out other pieces of knowledge that are consequences of it . and then use each new result to deduce something even more complicated . it can be added to the toolbox.” which is a fancy word for the logical deduction of the consequences of our original definitions and assumptions . the economic principles we will develop in this book are all logical implications of the fact that there are other people with minds who try to achieve their own goals . A geometry textbook will start with the most basic theorems. For example.e . more difficult theorems can invoke this earlier theorem in one of their steps . “John Doe is acting with a purpose in mind . In standard (i . then we can draw a new.” Right now we won’t list any of these results. because this difference is key to developing useful economic principles . In other words. the procedure or method of geometry is quite similar to what we’ll do in this book to build up basic economic principles .” Once that (very simple) theorem is proved. For example. Rather than looking to physics or chemistry for guidance on how to develop good economic principles. “euclidean”) geometry. a much better role model is geometry . Once we have our starting definitions and assumptions in hand. early on a simple theorem may run like this: “If we start out with four lines that form a rectangle. and so forth . we explain what we mean by the angle formed at the intersection of two lines. we start with some basic definitions and assumptions that seem reasonable enough . In the next lesson we’ll define some concepts (such as profit and cost) and show their relation to our basic assumption that events in the social world are driven by purposeful actions .Lesson 2: How We Develop Economic Principles
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earlier in this lesson we focused on the important distinction between purposeful action versus mindless behavior.

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insights. However. and the ruler you used to measure the lines was an imprecise tool. you can take a ruler and a compass (used to measure angles) and “test” the theorem out on triangles that you draw on a piece of paper . notice that it doesn’t make sense to ask a mathematician to go out and “test” the theorems in a geometry textbook . then the following equation will hold:
c a
b a2 + b2 = c2 Once you have seen an actual proof of the Pythagorean theorem. you’ll find that in practice the theorem won’t appear to be exactly true.1 inches . you understand that it must be true . by building on the previous lessons and by introducing new scenarios where we can apply our earlier results . Yet if you get such “falsifications” of the theorem.9 degrees). to amuse yourself. and point them out to a mathematician. the Pythagorean theorem says that if you have a triangle with a 90-degree angle. and you label each side with a letter. First.2 inches while the righthand side comes out at 10 .
. which is probably the most famous of all geometrical results . At this stage. consider the Pythagorean theorem. he will explain that the triangle you were measuring did not really have an exactly 90-degree angle after all (maybe it was 89 . For example. there are two important observations you should make about the example of geometry . you might find that the left-hand side of the equation adds up to 10 . since it only has so many notches on it and in practice you were “eyeballing” how long each line was to some extent .

You will not need to go out and test the propositions to see if they’re true. And if someone asks us whether the data “confirm or reject” our economic principle.” We now move on to the second important observation you should take away from our discussion of geometry: Just because something is logically deduced from earlier definitions and assumptions (sometimes called axioms). For example. Once we have proved a particular economic principle or law. at least in principle. deductive proofs in a geometry class. the economist simply concludes. even though people bought more units of the good .Lesson 2: How We Develop Economic Principles
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the important point is that the mathematician knows that the Pythagorean theorem is true. a rise in price will lead to a drop in the quantity demanded of a product or service . An engineer who sets out to build a bridge will have a much better shot if he has previously studied the logical. “Well. the resulting proposition might still contain important and useful information about the real world . logical deductions from the initial assumptions . the same is true (we hope!) for the economic principles and laws contained in this book . we can respond that the question is nonsense . even though (in a sense) all the theorems in the textbook are “merely” transformations of the information that was already contained in the initial assumptions . and yet everyone would agree that studying geometry is certainly useful .” now if we try to “test” the Law of Demand. We stress this point because many people think that a field of study can be “scientific” and provide “information about the real world” only if its propositions can. this requirement is obviously not fulfilled in the case of geometry. we can put it in our back pocket and use it in the future to help in proving a more difficult result . step-by-step. we will certainly be able to come up with historical episodes where the price of something rose. be refuted by experiments or measurements . we will learn in Lesson 11 the Law of Demand. this finding doesn’t blow up the Law of Demand. this is a good analogy for how we derive economic principles or laws . and then we begin logically deducing further results . because any apparent falsification would simply mean
. ‘other things’ must not have been equal . because he can prove it using indisputable. An apparent “falsification” of the economic law would really just mean that the initial assumptions weren’t satisfied . We start with some definitions and the assumption that there is a mind at work. which states that “other things equal.

will actually allow you to make sense of the real world in all its complexity .” However. You will do much better navigating the economy. once you have mastered the logical (yet un-testable) lessons in this book . and making sense of its outcomes.26
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that the particular assumptions used in the proof were lacking at the time of the “test .
. you will find that gaining this “armchair knowledge” through careful introspection and logical reasoning.

• The natural sciences include fields such as physics. In the social sciences. and deduces the logical implications from it. and controlled experiments are much more difficult to perform. They study different aspects of human behavior. including economics. and economics. They enjoy success because these objects seem to obey a constant set of fairly simple rules. who is trying to achieve a goal. chemistry. Mindless behavior refers to motions in the physical world that are the result of “mere nature” and not the intentions of another thinking being. and meteorology. • The natural sciences develop theories that try to predict the behavior of mindless objects with better and better accuracy.
. psychology. and because in many settings they can perform controlled experiments. They study the natural world and try to deduce the “laws of nature. the economist relies on his own experience of purposeful action. In this respect economics is closer to geometry than to physics.” The social sciences include such fields as sociology. To develop economic principles. including our interactions with each other in society. the objects of study have minds of their own.Lesson 2: How We Develop Economic Principles
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Lesson Recap •••
• A purposeful action is performed by a conscious being with a mind.

Austrian economics: A school of thought (inspired by Carl Menger and others who happened to be Austrian) that blames recessions on government interference with the economy. Logical deduction: A form of reasoning that starts from one or more axioms and moves step-by-step to reach a conclusion . For example. Keynesian economics: A school of thought (inspired by John Maynard Keynes) that prescribes government budget deficits as a way to lift the economy out of recession and restore full employment . but are assumed to be true in order to prove other. less obvious. behavior that has a goal . Axioms are not proved. Budget deficit: the amount the government must borrow when it spends more than it collects in taxes and other sources of revenue . and recommends tax and spending cuts to help the economy during a recession .28
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new Terms
Purposeful action: An activity undertaken for a conscious reason. the method of constructing a straight line between two points could be an axiom in a geometry textbook . statements . Axioms: the starting assumptions or foundations in a deductive system .
.

*Are brain and mind interchangeable terms? 4. is that a purposeful action? 2. Does “purposeful action” include mistakes? 3.Lesson 2: How We Develop Economic Principles
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sTudy QuesTions
1. If someone sneezes when pepper is thrown in his face. **Would you classify Intelligent Design theory as a natural or social science?
. Can we perform controlled experiments to test economic theories? 5.

.

• The proper way to think about preferences. as outside analysts. or scientific. we are going to spin out some of the logical implications of our decision to study exchanges . and then go test these predictions against our observations of the world .Lesson 3
Economic Concepts Implied By Action
In this lesson you will learn:
• Why only individuals. (After all.
31
. everything in economics is ultimately connected to the fact that we. are imputing conscious motives behind the events we are trying to describe . • How economists use preferences to explain individual choices. economics studies the former. not collectives. In this lesson. can make choices.
Introduction
I
n the previous lesson we stressed the distinction between purposeful action versus mindless behavior . to repeat the message from the previous lesson: note that we are not going to make a bunch of predictions from our “theory” that people engage in conscious exchanges. study of exchanges . We can’t even classify a physical object as “money”—let alone give an explanation of its purchasing power—unless we “get inside the heads” of the people who are passing around various pieces of this object . people pass germs around too. but we don’t classify them as money!) economics is the methodical. An exchange—in the sense that we use it in this book—is very definitely a purposeful action .

But he does know that the killer had a goal in mind—no matter what the extenuating circumstances may be. by supposing that some other. A detective can look at a blood-soaked kitchen and say. the
. On the other hand. this is a perfectly good hypothesis.” Just to make sure you really understand the concept. our rule holds: these people aren’t blaming “nature” for what happened. If you buy into the claim that we can usefully describe other people as engaging in goal-seeking behavior.” the detective can thus explain the physical arrangement of the kitchen. “somebody killed this poor woman—that butcher knife didn’t stab her through some freak accident . For whatever reason. intelligent individual consciously chose to act to kill the victim . to say that a conscious intelligence influenced events. now we don’t have to actually know the precise identity of the individual. After all. then it would be nonsense—because it just doesn’t seem helpful to explain a rock’s behavior as due to purposeful action . but believe me it was an accident . this obviously implies that there is some individual performing the action . you’ll see that all we’re really doing in this lesson is unpacking the knowledge that was already contained in the very notion of “purposeful action” in the first place . Again. in order to conclude that an individual has taken a purposeful action . such as a rock falling off a cliff. even though the detective (as yet) doesn’t know anything else about the actual killer . there are plenty of people who claim that their best explanation for what happened to them was that they were abducted by aliens and subjected to all sorts of unpleasant sensory experiences . then you will naturally understand our elaborations of that idea in the present lesson . nobody is going to believe him if he says. they are instead saying that intelligent beings influenced events .
Only Individuals Act
If we as economists are going to explain an event by referring to a purposeful action. “sure I was holding the knife when this happened. implies that there must be some intelligent being to whom the consciousness belongs . if you tried to apply the concepts in this lesson to a purely mechanical process. we note that the “individual” behind an action doesn’t necessarily need to be a human being .32
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no.

But going from this logical conclusion to the next step of identifying a particular person as the killer. (there can’t be an action without an actor . we can consider a more fanciful example . we are necessarily supposing that there must be an intelligent individual carrying out the action . now in practice. For a different example. the psychiatrist might think. when trying to arrest the actual killer . Once the psychiatrist decides to interpret the movements of the hand and pen as purposeful action—as opposed to a mere reflex—then he logically must conclude that there is an intelligent being with a motive who is moving the pen in order to achieve some goal . “that’s my sweet patient sally paying me for this week’s services as I help her with her split personality syndrome. a religious person might interpret the sudden remission of her cancer as due to the intervention of God . our attempt to link up a specific action with a specific actor is based on more than simple logic . In this case. But the important point for our purposes is that the detective’s decision to classify a bloody kitchen as a crime scene necessarily means that there must be a killer (or killers) . and thus logically he must also believe that there is some conscious individual performing this action .) so the connection between an action and an actor is a logical one. requires more than mere logic . if the psychiatrist jumps to the conclusion that the intelligent being is the personality
. snippy. there is more than a logical deduction involved. the psychiatrist classifies this as a purposeful action. In this example.Lesson 3: Economic Concepts Implied By Action
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aliens had the goal of probing Billy Bob as he drove his pickup truck home one dark night.” when in reality it is sally’s alter-ego. However. For example. But he might use faulty DnA tests to end up arresting the wrong guy . to drive home the subtle interconnections of logical and empirical reasoning. and the aliens acted on that desire . she too is explaining events in the physical world by reference to the purposeful action of an intelligent individual—one who in this case doesn’t possess a physical body . However. who isn’t filling out the check at all but instead is writing “YOu ARe tOO nOsY!!” on the paper before handing it over to him . we again have to keep in mind the limits of logical deduction . when the detective decides “this is a homicide. so we see.” he is logically implying that there must have been (at least one) killer . suppose a psychiatrist can see the left hand belonging to one of his patients as it grabs a pen and begins spreading ink onto a check . When we decide to interpret an event as a purposeful action. flowing out of the very concept of “purposeful action” itself .

“In 1941 Japan attacked the united states . For example. it means that when an economist tries to explain an event by reference to purposeful actions.” strictly speaking. which go far beyond the scope of a book on economics principles . this statement sounds obvious. and he might be wrong . Individual Japanese pilots flew planes and attacked ships belonging to the u .” We are brushing up against deep philosophical issues once again.” and that she is moving the pen in order to give him payment for his services.s . then the psychiatrist is going beyond the range of logical deduction. in everyday life we do a lot more than simply rely on logical deductions once we decide to interpret an event as a purposeful action . such that many many soldiers chose to obey those orders and carried out purposeful
. “Bill was thirsty so he decided to drink something . when we talk like this we are referring to an intangible. without the other empirical evidence in a given case that may or may not lead us to a fuller explanation . he ultimately must break it down into the motivations or goals of the individuals involved . this is nonsense . an historian might write.” Although we don’t usually stop to think about it. We use all sorts of empirical evidence to refine our understanding of what we observed . As these examples illustrate. But economic theory focuses on the knowledge we can deduce merely from the fact of purposeful action itself. In this section. “Bill’s body . so when we see the physical body associated with “Bill” pouring a can of soda down its throat. Really what happened is that Joseph stalin gave orders to his subordinates. we naturally describe this by saying. generally speaking we associate each human body with one specific mind (and vice versa) .34
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he knows as “sally. the statement “stalin occupied east Germany” is at least sensible (since stalin is an individual). who in turn relayed them to their subordinates and so on. Barring odd cases such as multiple personalities or hypnotic control. but it is surprising how casually people—even respected social scientists—ignore the rule . navy . the actor). we only need to make one more point: Because a purposeful action is associated with a single individual (namely. but it’s nonetheless misleading if interpreted literally . conscious will called “Bill” that tries to get its way by influencing the components of the glob of cells that we label. “Japan” isn’t an individual and so can’t take purposeful actions (such as bombing Pearl Harbor) .

In many cases this sloppy use of language is fine. Make up your mind!” In reality.Lesson 3: Economic Concepts Implied By Action
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actions that resulted in a new (and scary) political situation for the people living in east Germany . to say that “governments” act is merely a metaphor.” or “States. actually. etc . “Chicago just kicked a field goal to tie the game!” everyone knows what he means by that statement. no one will be misled into believing that somehow a lifeless geographical location managed to block burly men long enough to propel a pigskin between two posts . there are individuals—politicians. Economy. 2004). pp. while on the other hand it pays ad agencies to develop anti-smoking campaigns . 2–3
However. bureaucrats. in many cases this sloppy use of language is very dangerous. many people would endorse the following statement: “Man our government is so incompetent and dumb! On the one hand it pays farmers to grow tobacco. judges.: Ludwig von Mises Institute. There are no such things as ends of or actions by “groups. “Societies” or “groups” have no independent existence aside from the actions of their individual members. Instead.” which do not take place as actions by various specific individuals. there is no such thing as “the government” that has a mind of its own and can perform purposeful actions . there is no danger of confusion when a sports fan yells out from his office cubicle. Man. certain individuals are in a certain relationship with other individuals and act in a way that they and the other individuals recognize as “governmental. Ala. Thus. leading people to reach the wrong conclusions about the world .“ —Murray Rothbard. and State (Auburn. For example.” Only individuals have ends and can act to attain them. Different combinations
.—belonging to the government who enjoy special privileges because of their status .” “collectives.
Only Individuals Act
The first truth to be discovered about human action is that it can be undertaken only by individual “actors.

people act the way they do because they prefer the world to unfold one way. When we say that an individual performs a purposeful action. we are implicitly saying that they have opinions or desires about how the world should unfold . but it is actually dangerously misleading .36
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of (some of) these individuals make conscious decisions to steer tax dollars toward tobacco farmers and anti-smoking campaigns . we are also deciding that Bill himself must believe that drinking soda can relieve thirst .)
Individuals Have Preferences
Besides the (obvious) point that an action requires an actor. the people who discovered it might have no idea that puncturing the hard shells and pouring the dark liquid into their mouths would relieve the unpleasant
.” After all.” is that we can read between the lines. rather than another . For example. as it were. there is another unspoken truth that is packed into our simple statement about Bill’s chugging of the soda . Remember. but there’s a simple explanation for that too: government officials routinely lie . As you may have noticed. we use the word preferences to describe these feelings. “the pilot landed the helicopter because he wanted to use the bathroom .” we are automatically also saying (even if we don’t speak the words). intentional actions by others. “Bill drank the soda because he was thirsty.” But we would say. you will realize that there are perfectly sensible reasons for the actions of government officials .” so we see that when we discuss purposeful. (notice that lying is itself a purposeful action . and fill in the unspoken claim that Bill is unhappy with his condition of being thirsty . . we mean that he has a purpose or a goal in mind . when we say. their actions often don’t make any sense when compared to the official justifications given for the actions. and Bill prefers to not be thirsty . When we decide to classify his behavior as a purposeful action. In economics. we can draw further deductions .” the reason it does make sense to say. “ . “Bill drank the soda because he was thirsty. . “Bill drank the soda because 2+2=4 . the simplistic approach to viewing these programs as actions taken by “the government” is not only technically inaccurate. if a case of soda fell out of an airplane into a primitive village. After reading the lessons in this book. we don’t say that the baseball “wants to fall back to the ground . it wouldn’t make much sense to say. After all.

” these two statements are perfectly compatible. good for the patient . it does not make sense to say. In contrast. but 280 calories for John . it can’t differ from person to person . It’s important to realize that a person’s beliefs can be wrong. is akin to the difference between an opinion versus a fact . or their musicians might incorporate them into other forms of purposeful action. For example.)1 We will develop the point more fully in the next lesson. but here we mention that people use parts of the world in order to achieve their goals . (And they certainly wouldn’t realize how much it would rot their teeth . and yet still motivate a purposeful action .” (On the other hand. It makes sense to say. if we went back in time and observed doctors in the 1800s placing leeches on patients.” the number of calories in a serving of ice cream is an objective fact. “the ice cream has 300 calories for Mary. and because they believe that blood-letting is an effective treatment . because preferences (in this case. “Mary prefers vanilla ice cream to chocolate. the difference between a subjective versus an objective statement. Loosely speaking. “they are doing that on purpose. we would say.) Instead.Lesson 3: Economic Concepts Implied By Action
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feelings of thirst .
1
. having nothing to do with thirst .
Preferences Are Subjective
Because preferences are tied to specific individuals. but clearly the earlier practice was not. we say that preferences are subjective . economists describe this by saying people use goods and services to satisfy their preferences . in general. because they prefer the patients to be healthy rather than sick. Mary and John might disagree with each other about how many calories the ice
there are apparently rare cases in which even modern doctors would recommend blood-letting as an effective treatment. preferences for ice cream flavors) are subjective and can differ from person to person . Philosophers describe this by saying people use means to achieve their ends . someone armed with more accurate medical knowledge might place leeches on his enemy because he prefers him to be weak and he believes that drawing away blood will achieve this goal . but John prefers chocolate ice cream to vanilla . they might consider the cans sacred (since they fell from a giant flying object that they had never seen before).

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cream has. or that they are saying no one can judge the actions of anyone else . or that murder “is a personal choice . this recognition in no way condones the preferences of particular individuals . he can—with perfect consistency—then ground his teenage son when he catches him smoking in the garage with his hooligan friends . As we will see more clearly in Lesson 6. there is no “fact of the matter” concerning which ice cream tastes better. Mary and John can disagree with each other about which flavor of ice cream tastes better—with neither one nor the other being wrong—because preferences are subjective . If we see Mary go up to the counter and choose vanilla ice cream. an economist can’t possibly explain the price of tobacco without acknowledging that some people prefer to spend their money on cigarettes. Yet both of them could be simultaneously “correct” when Mary says.” and try to understand what desires are causing the killer to act the way he is . the way there definitely is an objective way to demonstrate how many calories are in a serving . but in that case at least one of them is simply mistaken .”
. the profiler needs to “think like the killer. Warning! Many critics of economics—both from the progressive “left wing” as well as the religious “right wing”—totally misunderstand what economists mean by saying that preferences are subjective .” while John says the opposite . Obviously this analysis doesn’t mean that the profiler is neutral with regard to the actions the killer takes. to repeat. we are simply tracing out the logical implications of our decision to classify observed behavior as purposeful action . “Vanilla tastes better than chocolate. For example. forget about economics and consider an FBI profiler . to track down a serial killer. rather than on other products . while we see John go up to the counter and order chocolate. the only satisfactory way to explain market prices is to first recognize that preferences are subjective . we won’t get anywhere in our understanding unless we realize that Mary and John have different tastes when it comes to ice cream flavors . because economists aren’t saying those things at all! Remember. these critics think that economists are somehow endorsing moral relativism. But these complaints are without merit. After the economist states this fact. If you’re still not seeing the distinction between professional analysis versus personal beliefs.

even if Jane announces.Lesson 3: Economic Concepts Implied By Action
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to sum up: When people engage in purposeful actions.” But it’s important for you to see that this type of talk makes no sense in terms of the preferences that we use in economic reasoning . what does it really mean—from the standpoint of pure economic logic—to say that Mary has a preference for vanilla over chocolate? All it means is that. But that is the same thing we can say about her sister Jane. the preferences can only reveal a ranking of goals . faced with a choice between the two flavors. scientific meaning as well. so in terms of logical deductions that we can make based on a person’s purposeful actions. indeed. and it doesn’t overlap perfectly with the everyday use of the term work in conversations . all we can say as economists is that both girls exhibit a preference for vanilla over chocolate . By analogy.
Preferences Are a Ranking. In order to explain exchanges. this purposeful action only indicates that she prefers vanilla . that statement doesn’t even make sense in terms of strict economic logic . In everyday conversation. We can’t determine “how much” Mary prefers vanilla over chocolate.
2
. We can take this train of thought further to drive home the lesson . economists must recognize that preferences are subjective . Not a Measurement Using Numbers
Because preferences are tied to a person’s exchanges. whose friends would testify that she has only a “slight” preference for vanilla . we’re merely pointing out that the term preferences has a very precise meaning in economics .2 After all. When Mary chooses vanilla over chocolate ice cream. they are motivated by desires that are not necessarily identical from person to person . when faced with a choice. “I just barely prefer vanilla to chocolate!” that wouldn’t give an economist the ability to conclude that her preference for vanilla is “less
We’re not saying people are using language in a sloppy manner in everyday conversation. Jane too. Mary would pick vanilla . would pick vanilla over chocolate . we all know what it means to say that “Mary really prefers vanilla over chocolate but her sister Jane only slightly prefers vanilla to chocolate . in physics the term work has a very precise.

We can push it further and ask sally to rank her friends . no. it doesn’t actually shed more understanding on the process of exchange . consider the analogy of friendship .
At this stage of the book. Remember. versus yelling something else or keeping her mouth shut . As you will learn in upcoming lessons. but even so there’s still no such thing as an objective “unit of friendship” behind the scenes. the use of mathematical utility functions is very harmful when learning basic economic principles. but it’s important for you to grasp the point now. “Does Bill possess at least 30% more friendship than Joe?” we would have entered the realm of the absurd . we are using the notion of a person’s subjective preferences to explain the concrete actions that the person takes . that Mary is her second-best friend. People take actions to satisfy their most important preferences. or to achieve their highest goals . and that Joe is her third-best friend . the moral of this story is that it makes sense to rank friends. that informs economists about the person’s preferences all right. driving our ranking . before we explain how prices are formed in later lessons . but only because the utterance itself is a purposeful action!3 to help you remember the points of this lesson. For example. If someone utters a statement. it would merely allow the economist to conclude that Jane preferred to yell that particular sentence. because it often causes the student to forget where the notion of preference comes from in the first place . these examples may seem tedious. we need to assume that people have a ranking of goals or ends .
3
. such talk is perfectly meaningful . the same is true with preferences in general. to understand and describe exchanges. this alternate approach is only useful in coming up with specific answers to contrived numerical problems. But what if we then asked sally how much better a friend Bill was than Mary? now things start to sound a little strange . And if we asked her. We do not have to say that people have a mathematical “utility function” that they seek to maximize. even though such talk is commonplace in other economics textbooks .40
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Lessons for the Young Economist
intense” than Mary’s . she might say that Bill is her best friend. at least as we use them in economics . sally might have three friends. In fact. and so we could say that in her mind she holds feelings of friendship for each of them .

So when the function assigns “55 utils” to a bowl of vanilla ice cream but only “34 utils” to the chocolate.Lesson 3: Economic Concepts Implied By Action
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An Alternate View
Even professional economists do not always heed the principle that preferences are a ranking.D.7 utils” to the vanilla and “2. though common. so that (say) Mary gets “55 utils” from vanilla but only “34 utils” from chocolate.D. all that really means is that Mary would choose the former over the latter. are dangerous because they can mislead you into thinking that we are measuring the amount of psychic satisfaction an individual derives from particular actions. But then many economics textbooks push it further and start assigning numbers to measure how much utility. the Ph. “Mary chose vanilla ice cream because it gave her more utility than the chocolate ice cream would have given her. such talk is meaningless. the textbook will explain that “utils” don’t really exist. economists can use mathematical utility functions just as a convenient shortcut to describing preference rankings.-level textbook will explain. It may be that one day neuroscientists come up with an objective way to quantify various degrees of happiness. Instead. economists often use the term utility to describe how much pleasure or satisfaction a person gets from a particular situation. The utility function could just as well have assigned “18.level class. we will not be using the confusing terminology of “utils. we use terms like “preferences” as a way to
. such that they can coherently talk about Mary being “three times more satisfied” than Bill. If you are taking a Ph. the important thing is that Mary acts “as if” she is maximizing this arbitrary mathematical function. and so in order to “maximize utility” she obviously chooses the vanilla. so good.” So far.3 utils” to the chocolate. In economics. our point here remains the same: In the field of economics. For example. In this book.” and we won’t be performing calculus on “utility functions” the way other economics textbooks do. But even if this happens. These practices. the way “kilograms” are an objective unit of weight and “meters” are an objective unit of height. Therefore they might describe our scenario by saying. not a measurement.

At that time. When someone chooses one thing over another. for example.42
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explain or describe the purposeful actions of individuals. but economic logic per se can go no further. far from it! The economist is actually being humble here by admitting the limits of what economic reasoning can say about a given event. It makes sense to ask. Many people (try to) justify progressive income taxation. “What is the total weight of the population?” or “What is the average age of the population?” It does not make sense to ask. In Lesson 18 we will examine the consequences of progressive income taxation . whereas handing out $1. and cannot even be measured or quantified for each individual. we will see how subjective preference rankings interact to yield objective market prices.000 to a thousand different homeless people will greatly boost each of their utilities . then obviously it would make no sense at all to try to combine or aggregate individual preferences into “social” preferences . The economist isn’t claiming to have all the answers. In Lesson 6. You can’t add up different amounts of utility from various people . In fact. Psychologists or neuroscientists (or even common sense) might shed more light on the event. “What is the total preferences of the population?” or “What is the average amount of utility per person?”
.” the idea is that taking $1 million from Bill Gates won’t lower his utility very much. For now. total or “social” utility has been increased by the redistribution of some of Bill Gates’s wealth . all we can conclude is that the person preferred the chosen item over the discarded item. even professional economists often engage in just this type of reasoning . we point out that the typical justification for it is absurd . by claiming that “a dollar means more to a poor man than to a rich man . unfortunately. if you use the alternate term preferences it will be more apparent why combining them from different people is an impossible task . the typical argument goes. therefore.
Different Individuals’ Preferences Can’t Be Combined
If preferences are subjective to each individual. you will understand better why we are stressing these points in this lesson.

or 3rd-best friend. sally thinks Bill is a better friend than Joe. even if Joe and Bill are each “the same person” whether hanging out with sally or Larry. on the other hand. they will eventually become friends . her second-best friend is Mary. we don’t even have to assume that Joe and Bill act differently depending on whether they are with sally or Larry . because preferences are subjective . this will cause a big fight between Adrian and sally. Maybe Joe is always making gross noises with his armpit. notice that even among their shared friends. I’ll write a note in sally’s handwriting that says. His best friend is Joe. it’s still perfectly sensible for them to be ranked differently because—you guessed it—preferences are subjective . sally and Larry don’t have the same ranking order . while Larry thinks that Joe is a better friend than Bill . he will be ranked
to explain the difference in friendship rankings.Lesson 3: Economic Concepts Implied By Action
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to make sure you understand just how nonsensical it is to (attempt to) perform arithmetical operations on different people’s preference rankings. there is nothing strange about this. and so on . make sure you understand the table: sally has five friends total . so he won’t be her friend anymore . once again let’s switch to the analogy of friendship . only has two friends . “this is terrible! Poor Larry doesn’t have as many friends as popular sally! I have a great idea to make things fairer . suppose that sally and Larry have the following “friendship rankings”:
Friendship Rankings
Sally
1st (best): Bill 2nd: Mary 3rd: Joe 4th: tom 5th: Adrian
Larry
1st (best): Joe 2nd: Bill 3rd: (none) 4th: (none) 5th: (none)
Before continuing. and Bill is his second-best friend . and sally thinks it’s disgusting while Larry thinks it’s hilarious .
4
. Larry. ‘You smell!’ and put it in Adrian’s lunch bag . 2nd. Her best friend is Bill.4 now suppose a busybody school administrator comes along and says. then I’ll arrange it so that Adrian sits near Larry on the school bus . but no matter what. I can’t predict whether Adrian will become Larry’s 1st.

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higher as a friend of Larry than he was as a friend of sally .” Obviously the above story is quite silly . Perhaps proponents of progressive taxation can justify it on other grounds. Hopefully you can now see that trying to increase “social utility” by taking money from a rich man and giving it to a poor man. But we have used a silly story to demonstrate the silliness of trying to add up subjective. is simply nonsensical . individual preferences . through my benevolent intervention. I will have increased the total amount of friendship among the children . but appealing to the economic concept of preferences (or utility) doesn’t get the job done .

. These are the goals that a person tries to achieve through actions. • Economists say that preferences are subjective.Lesson 3: Economic Concepts Implied By Action
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Lesson Recap •••
• Once we decide to classify certain events as purposeful actions. Although people can act in combination with each other. • We interpret someone’s action by saying he or she has preferences. it simply recognizes that people have different tastes. we can make further logical deductions. for every action there must be an actor. meaning that they are unique to each person. an intelligent person who performed the action. any particular action is performed only by one person. To call preferences subjective doesn’t condone or applaud them. For example.

Goods: scarce physical items that an individual values because they can help to satisfy his preferences . Service: A person’s performance of a task that another person values because it helps to satisfy preferences .46
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new Terms
Preferences: An individual’s goals or desires .” Utility: A term common in economics textbooks to describe how much value a person gets from a good or service . Progressive income taxation: A system that taxes individuals or corporations at higher rates based on the level of income . Subjective: unique to each individual. services are the “goods” that people create through their labor power . “in the eye of the beholder . economists interpret a person’s actions as attempts to satisfy his or her preferences .
.

4. Why do statements about a man’s actions (implicitly) involve his beliefs as well? 3. “Germany attacked France”? 2.Lesson 3: Economic Concepts Implied By Action
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sTudy QuesTions
1. What does it mean when economists say preferences are subjective? 5. *Does economics say you shouldn’t give money to charity?
. Can purposeful action be based on a faulty belief? Give examples. Why is it questionable to say.

.

and you also learned that the apparently simple decision to classify human behavior as “purposeful action” leads to many insights that will help us explain how modern market economies operate . this is what most people probably think that a book on economics is supposed to do! Yet before we dive into the deep end.
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. in the present lesson—the last of our “Foundations” section—we will sketch out some of the basic economic truths that apply even in the very simple case of a single person on a remote island .
Introduction
I
n the first three lessons you learned that economics is the study of exchanges.Lesson 4
“Robinson Crusoe” Economics
In this lesson you will learn:
• How even a one-man economy illustrates economic concepts and categories. we will begin our full-blown analysis of a market economy with buyers and sellers using money in their transactions . there are a surprising number of conclusions we can draw even in this extremely limited case . • The importance of saving and investment. • How economists explain individual choices. In Part II of this book.

so that events transpire in a manner more to his liking . He climbs to the top of a hill and surveys the island .
Crusoe Creates Goods With His Mind Powers
All alone on his tropical island.
1
. Crusoe first needs to see what he has to work with . with Crusoe. we should start with just one person and make sure we understand what makes him tick . as well as some small streams of running water in the distance . these general principles will still hold true. Crusoe quickly realizes that he doesn’t like the way things are developing . You probably realized. But to avoid overwhelming students at step one. Rather than resign himself to his fate. many critics have derided this so-called “Robinson Crusoe” economics. there are several rocks of varying sizes. His stomach is starting to rumble. named after the shipwrecked mariner in Daniel Defoe’s famous novel . At this point we can stop and describe the situation in terms of economic concepts . even when Crusoe is rescued and returned to civilization . Before he can make a sensible decision on how to proceed. as well as strong vines . given his circumstances . and would be among the facts that you would consider if you found yourself in
Modern readers might identify more with tom Hanks’s character in the 2000 movie Cast Away .50
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Over the years. we are here starting out with the simpler case in which Crusoe is (initially) all by himself and must act to improve his situation. Crusoe’s mind begins whirring as he decides what to do first . Crusoe decides to take action to alter the unfolding of history. his throat is dry and itchy. and he doesn’t see any natural shelter from the horrific rainstorms that must occasionally strike the island . As you will see. in this lesson we are developing general principles about an individual’s purposeful actions in the face of scarcity . we are not saying that an isolated person is an accurate description of a modern economy . Rather. we are saying that before we can analyze an economy composed of billions of interacting people.1 Obviously. Crusoe notes that there are plenty of coconut trees. why the particular items mentioned in the previous paragraph were relevant to his situation.

After all. regardless of his actions . In contrast. even so Crusoe must be considerate when cutting them down to make a fishing net. Crusoe doesn’t need to economize these general. Crusoe doesn’t need to worry about sprinting too fast and thereby “using up all the oxygen. In economic jargon. this island is subject to the earth’s gravitational pull. But Crusoe wouldn’t focus on them when formulating his plans. and so on . Crusoe might later regret the influence on them. coconuts. (He also wouldn’t burn down a bunch of coconut trees just for kicks . until he finds another source of food (such as fish after he constructs some tools). Crusoe can’t simultaneously use those same rocks when building a fire . because no action Crusoe takes will render them less useful to the achievement of his goals . background conditions the way he needs to exercise stewardship over the coconuts. then he can’t knock down coconuts with it . meaning I won’t drift off into outer space and freeze to death . because this will impair his ability to satisfy goals in the future . etc . are called goods . Crusoe took an inventory of the goods at his disposal . Crusoe needs to make sure he doesn’t eat his coconuts too quickly . And the presence of an atmosphere is very good for transmitting sound waves. And even if the supply of vines is ubiquitous. and contribute to the achievement of his goals . meaning I won’t suffocate . As these examples all demonstrate. Crusoe needs to think through the consequences of his actions whenever his plans involve the rocks. because it takes him time to walk deeper into the jungle and get more vines . there
If Crusoe burns the stick as kindling.
2
. vines. so that I can hear a storm approaching . the distinctive mark of scarcity is that there are tradeoffs involved . and could help the person achieve even more goals if there were more of these items available. there is a plentiful supply of oxygen here. he appraised himself of the stockpile of physical items available for his use that exhibited scarcity . vines.” these attributes of the island are also extremely useful to Crusoe. background conditions like gravity and oxygen are not (typically) goods in the economic sense.) If he decides to use certain rocks in order to make a shelter. Because these items are scarce.” and he doesn’t face any tradeoffs in relying on gravity when knocking down coconuts with a long stick . that is. Items that can help a person achieve his or her goals. Crusoe could have truthfully said.Lesson 4: “Robinson Crusoe” Economics
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Crusoe’s place . because they aren’t scarce . But gravity will still operate just the same. “Hmm.2 Further.

Crusoe would not consider it a good at all . but rather because (a) it can serve to alleviate hunger. A coconut on the tropical island is not a good because of its physical characteristics per se. certain plants on the island might have medicinal properties. On the one hand. they are only indirectly useful because they help Crusoe to obtain more consumer goods .
. and if it were the only object on the island. and hence they are not classified as economic goods . If Crusoe were ignorant of the fact that coconuts are edible. But because there are coconuts hanging on trees—some of which are out of Crusoe’s reach—suddenly the stick acquires value indirectly . the running water in the stream can directly quench his thirst. doesn’t do anything for Crusoe. Crusoe recognizes that there are scarce items that can help him to directly achieve his goals . and (c) Crusoe is aware of point (a) . then those plants will not attain the status of economic goods . we can begin to make some distinctions . For example. (b) Crusoe would prefer to not feel hungry. On the other hand. even though it doesn’t directly satisfy hunger. and the coconuts can directly satisfy Crusoe’s hunger . and which would allow Crusoe to achieve more of his goals if he had more of such items—hence they are goods—but they are not directly useful to him . For a different example. a long stick. because it indirectly helps him to achieve his goal .52
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aren’t any goals that Crusoe could accomplish.” so although oxygen and gravity are necessary for his very life. For example. It’s important to realize that an object becomes a good when a person incorporates it into his plans . then he might not consider them as goods . in and of itself. economists call items such as the hypothetical stick producer goods or factors of production or means of production . economists call these consumer goods . Crusoe now considers the stick to be a good. Crusoe doesn’t have to economize on their use. there are items that are certainly useful. if only he had “more oxygen” or “more gravity .
Consumer Goods versus Producer Goods
now that we understand what goods are in general. but if Crusoe doesn’t know it.

the distinction between consumer versus producer goods is in the mind of the acting individual . it would be perfectly
.Lesson 4: “Robinson Crusoe” Economics
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As with goods in general. these include somewhat permanent items such as a flowing stream. For example. if the Incredible Hulk should wash up on Crusoe’s island. and Capital Goods
even within the class of producer goods. we can make more distinctions . the single most important and versatile producer good is Crusoe’s own labor. or a tree that will yield a flow of coconuts indefinitely.
Land. but also included are depletable resources such as a small deposit of tin that Crusoe can use to make cooking pans and fish hooks . those producer goods that are the direct gifts of nature are typically called land or natural resources . he might consider the stick a great device for scratching that hard-to-reach spot between his shoulder blades . In terms of the logic of economic principles. Labor. which is the flow of productive services Crusoe performs with his body . to the Hulk. the same physical stick would be a consumer good .

the very first capital good ever produced in human history. capital goods are those factors of production that were created by people .
3
Both components of this definition are important . On the other hand. and will only devote some of their scarce time to labor if it allows the achievement (indirectly) of more important ends than the leisure being sacrificed . which gives quite a good workout and can even leave his muscles sore the next day .. and a shelter that he creates out of rocks. economists have historically accorded labor special treatment. then they wouldn’t be capital goods either—instead they would be natural resources . brain. if he achieves direct satisfaction of goals through control of his hands.
4
Logically speaking.
5
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notice that leisure doesn’t necessarily imply lounging around on the beach. then economists call this leisure . Historically. and also because labor is the one producer good that is required for every production process . Crusoe might love swimming in the ocean. But before he can enjoy himself in this activity.3 Finally. economists have referred to the disutility of labor to underscore the fact that individuals directly enjoy leisure. and his labor . he first engages in the extremely boring—but physically undemanding—task of gathering small twigs for the night’s fire . and labor (or work) doesn’t necessarily imply physical exertion . but which he hadn’t created. examples of capital goods would be a fishing net that he constructs out of vines and his labor. If Crusoe created goods that were not factors of production.4 every capital good is produced from the combination of (at least one) natural resource and labor . When Crusoe devotes his physical efforts toward the indirect satisfaction of goals. leaves. And if Crusoe had goods that were factors of production. he is engaged in labor . because labor is the one factor of production that every individual possesses. Most capital goods are also produced with the help of (pre-existing) capital goods . mud. branches. in order to satisfy the goals he considers most important . However.5 For Crusoe on his island. they wouldn’t be capital goods—they would be consumer goods . etc . must have been made when someone used his labor to transform the raw gifts of nature into a factor of production .54
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sensible to group labor along with other natural resources that provided an indefinite flow of services (with adequate maintenance) . Crusoe will allocate his “body power” among labor and leisure activities.

that means his raw labor can extract 10 coconuts per day from the natural resources available to him on the island . Connecting all of these is the flow of time. after sufficient investment has been made to maintain next period’s gross income at the same level .Lesson 4: “Robinson Crusoe” Economics
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Income. saving. and investment in a modern market economy. If Crusoe devotes 10 hours per day to work. eating 10 coconuts per day provides enough nourishment to maintain Crusoe in decent health . and serve only to make the scenario concrete enough so that you can really think through the types of tradeoffs Crusoe faces .” Investment occurs when ingredients of production are devoted to future income. It’s easiest to explain with a numerical example . Obviously the following numbers are chosen for simplicity. But working 10 hours per day. In that light. and consumer goods (which include leisure) . suppose that with his bare hands.
technically. we quickly illustrate that these advanced concepts have their analogs even in the simple Crusoe economy . Crusoe knows that if he should ever become sick or injured. Crusoe can choose to save and invest today. while leaving the rest for leisure (which includes sleep). labor.
In Lesson 10 we will discuss in much greater detail the relationship between income. and Investment
We now know that Crusoe can separate his world into various types of scarce objects.
Income refers to the flow of new consumer goods (and services) that an individual has the potential to acquire during a period of time . gross income refers to the maximum amount of consumption during a specified time interval. with no weekend. Saving.
6
. he could easily die because of the vulnerability of his hand-to-mouth existence . Fortunately. and Crusoe’s understanding of how his actions now can alter his happiness in the future . capital goods. rather than immediate consumption . specifically. For now. it is “living below one’s means . whereas net income is the maximum amount of consumption possible. in the categories of natural resources.6 Saving occurs when someone consumes less than his income. in order to raise his future income . Besides the grueling schedule. Crusoe can find an appropriate tree to climb and knock down 1 coconut per hour . in which most exchanges involve money . is hardly an ideal lifestyle .

But he only eats (consumes) 8 coconuts each day. he once again resumes eating 10 coconuts per day—he consumes his full paycheck every day. but Crusoe realizes he can do much better . Crusoe continues to work 10 hours per day. Crusoe is a disciplined and resourceful man. gathering
We can assume that the coconuts don’t taste nearly as good. After living below his means in this fashion for 25 days.7 Because of his willingness to put in hard work and save its (literal) fruits. Crusoe decides to take two days off from climbing trees to knock down new coconuts for the stockpile . if Crusoe should come down with a tropical illness that makes him unable to work. but he also has a savings fund of 50 coconuts that he can draw down in case of emergency . For example. but are still edible. soon after assessing his situation on the island. Rather than living on the edge of starvation. In other words. Crusoe has settled into a comfortable routine: every day he picks a fresh batch of 10 coconuts and adds them to one side of his stockpile . the simple act of saving and accumulating consumption goods is very useful. Crusoe begins saving 20% of his income every day . Crusoe now has a buffer of ten days . But our hero isn’t taking a much needed vacation! On the contrary. by the tenth day after being knocked down from the tree . gathering (earning) 10 coconuts per day . Crusoe has accumulated a stockpile of 50 coconuts . therefore. After surveying the materials at his disposal. With this rotation. Relying on his stockpile of 50 coconuts. Crusoe has greatly enhanced his material position compared to his original situation . Crusoe still enjoys a full 10 coconuts (which still taste pretty good) per day. Crusoe sets out to invest his savings in a longrange venture. During the day. the main reason Crusoe stopped accumulating additional coconuts is that he discovered their taste begins to suffer five days after being knocked down from the tree . and sets aside (saves) 2 coconuts out of each day’s income .56
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there is a solution . which he expects will permanently increase his future flow of daily income . he eats the oldest 10 coconuts from the other side of his stockpile . and realizes that the ability to save and invest can greatly improve his standard of living . he has enough saved up to eat for ten days on half-rations . day in and day out.
7
. as it were . Crusoe spends the first day—all 10 hours—wandering the island. From that point on.

Crusoe eats 10 coconuts. Crusoe spends 4 hours per day knocking down 20 new coconuts. He discovers with great satisfaction that in a single hour. Crusoe’s stockpile has dwindled to 30 coconuts .9 He once again has five days’ worth of full-rations. Crusoe lays the branches on the ground. the sawed-off branch . Crusoe saves some of his new earnings for a few weeks. it will take him two full weeks to accumulate a stockpile of 100 coconuts . this is such a tremendous boon to his productivity that Crusoe now decides he’s been working too much! Rather than working 10 hours per day gathering food. he has only a collection of sturdy and long branches. If he only consumes 15 out of his daily income of 20 coconuts. reducing his stockpile down to 40 . the process is slow-going.
9
. he has no new coconuts to show for it . Crusoe now spends only 4 hours per day knocking them down .8 During this day. the next day Crusoe takes his capital good out for a spin .Lesson 4: “Robinson Crusoe” Economics
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branches of the appropriate length and thickness . Wanting to replenish his stockpile to the fullest amount that still allows for tasty coconuts.
8
starting on his first day of using the pole. this brings in a daily flow of 20 coconuts per day. Instead. then he uses the vines to tie the branches snugly to each other . During the second day.. even though he has worked all day. his labor power—aided by the new capital good—can yield 5 coconuts .
notice that the sharp rock is a natural resource that Crusoe uses with his labor in order to produce a capital good. Crusoe spends another 5 hours using sharp rocks to further prepare the branches . Finally. on the fifteenth day after he has constructed the pole—Crusoe can begin consuming the full 20 coconuts of his income per day . which he has transformed from their original shape and location . before he can safely snap it off the tree without ruining it . which he adds to the stockpile . in the remaining 3 hours of the second workday. In the new equilibrium.e . he needs to use a sharp rock to saw away at the branch. except now a “full-ration” means 20 coconuts per day . Crusoe has a new capital good: A long and sturdy pole . he eats the 20 oldest (ripest) coconuts in the stockpile . twice what he was “earning” with his bare hands . At the end of the second day. Crusoe has 30 coconuts in the stockpile . then he spends 2 hours cutting down vines and bringing them back to camp . During that same day. because when Crusoe spies a good candidate. until his stockpile has grown to 100 coconuts . end-to-end but with a large degree of overlap . After that point—i . But in addition to this (shrinking) stockpile of savings.

he had to put in 10 hours per day of fairly intensive work. in addition to spending 4 hours per day laboring in the collection of new coconuts. If Crusoe wants to permanently maintain his new. with an eighth day of intense work and no coconuts— Crusoe can smooth things out . What this means is that after the seventh day of using his brand new capital good. and to assemble the new pole . But after his wise investment in the construction of a capital good. as well as re-wrapping the entire pole with new vines . Crusoe finds that he only needs to spend 4 hours per day knocking down coconuts with the pole—a much easier task than climbing a tree and grabbing them with his bare hands . this way. he can’t enjoy 20 hours of leisure per day . Crusoe . which is frankly the upper limit of how many coconuts he would want to eat . higher standard of living. Moreover. In a typical day in the new equilibrium. Crusoe would find himself with a useless pole. On the morning of the eighth day. Crusoe would have to draw down on his coconut stockpile. suppose that after using the pole for a full week. In exchange for all that toil. after seven days have passed in a typical week. Crusoe must also devote some of his scarce time to the maintenance of his pole . since he wouldn’t be able to gather any new coconuts that day . the component branches wriggle out of their tight knots. and each end of the pole is quite battered . working to collect new vines and two new branches. there is one more important detail .
. Crusoe enjoyed 10 coconuts each day . He also gets to enjoy twice as many coconuts per day as before. now if Crusoe only works the minimum 4 hours per day. no. it’s hard to climb trees all day . collecting coconuts.58
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things are obviously looking up for Mr . For example. Crusoe will need to devote some time to replacing the two end branches. in addition to working so many hours. he can spend 4 hours knocking down 20 new coconuts to add to his stockpile (while of course eating the ripest 20 from the same stockpile of 100) . Before. he can only get away with this slacking for seven days . But then he also spends a fifth hour each day working on the preservation of his capital good . and he would have to spend (let’s say) 7 hours on that day. Rather than engage in this volatile schedule—seven days of light work with many coconuts.

and Crusoe never needs to eat a coconut older than five days . Crusoe only consumed his net income each day. because the last tasks—swapping out the end branches and retying it all together—take more than an hour. this complication comes from the fact that even though Crusoe takes 7 hours to repair a broken pole.
10
. as well as the first working hour of (the next week’s) first day. using their jargon. he can draw down on the stockpile . on a later day when Crusoe needs to devote more than the fifth hour to pole maintenance. Crusoe then invested his resources into the creation of a capital good that greatly augmented his labor productivity . (try asking your waiter for a complimentary glass
to make the story work out. because he invested enough of his gross income to just balance the depreciation of his capital good . By consuming less than his daily income—by living below his means—Crusoe saved coconuts in order to build up a fund to guard against sudden disruptions in his future income . all the numbers work out: the stockpile never falls below 100. technically Crusoe would have to use the fifth working hour of the seventh day. rather than comparing entire classes of goods against each other .10 In the jargon of economics. keep in mind that Crusoe has the option of devoting more than 4 hours of a given day to coconut collection (while still only consuming 20 that day). After the completion of the pole. the classic illustration of this new way of thinking is the so-called “waterdiamond paradox . according to the description we gave earlier . so that the stockpile temporarily exceeds 100 . it seems odd that the price of water should be so low—restaurants will serve it for free!—while the price of diamonds should be so high . Moreover. If you are a purist and really want to plot out exactly what Crusoe would do with his time for each day of the cycle.
Goods Are Valued Unit by Unit
One of the most important advances in economic theory was the realization that people valued goods unit by unit. he can’t spread that work out evenly as the last hour of each day for the course of a week. then. economists now say that people evaluate goods based on marginal utility .” At first glance. we can step back and describe what Crusoe has done . in order to swap out the two battered end branches and retie the whole pole with the new vines . With proper planning.Lesson 4: “Robinson Crusoe” Economics
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Crusoe will have performed the 7 hours’ worth of labor necessary to restore the pole after it has been worn down from a week of usage .

then the person would most probably pick the water . there aren’t enough diamonds to go around to satisfy all the uses people have for diamonds . and he has time to grab just one thing to rescue from the inferno . What object should he choose to grab as he runs from the fire? A superficial guess would say. economists would say that diamonds are scarcer than water .60
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filled with diamonds . it’s true that the way to explain the value of an object. But when this person makes actual choices in the real world. there is so much water available that any particular gallon of it. the whole building is ablaze . “Crusoe should take the coconut.) If economists think that the value of goods is ultimately related to humans trying to satisfy their subjective goals. that’s why any particular diamond is still quite valuable . how can diamonds possibly be more valuable than water? After all. Crusoe realizes he has to hurry outside before the shelter collapses on him. is to get inside the head of the person who values it and understand his goals . three different economists independently worked out the solution to this problem: Yes. rather than his
. he never faces the tradeoff of “all the water” versus “all the diamonds . Crusoe still has a stockpile of 99 more coconuts that are not near the fire . and leaves) . But in normal life. suppose one night Crusoe is careless and falls asleep while his campfire is still sending out embers . By the time Crusoe wakes up. In the early 1870s. Indeed. In contrast.” But that answer is wrong . assuming that the goal of avoiding starvation is more important to him than keeping a useless memento from civilization . At the very worst. all the sacrifice means is that Crusoe will have to settle for eating only 19 coconuts on some particular day (not even necessarily the next day).” If that really were the choice. the wind carries one right onto Crusoe’s humble shelter (constructed out of vines. you can’t satisfy too many goals if you die of thirst . For example. the only objects in the shelter are a fresh coconut and a watch that he was wearing at the time of his original shipwreck . has a very low value . branches. this principle of valuing goods by individual units applies in Robinson Crusoe’s world . That particular coconut will not mean the difference between starvation and nourishment .

the general principle is that Crusoe will evaluate goods unit by unit .Lesson 4: “Robinson Crusoe” Economics
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normal 20 . to put it simply.” However there is an important caveat . When Crusoe makes a choice. which they define as the subjective value placed on the next-best alternative that must be sacrificed because of a choice . Crusoe may simply decide to work an extra 12 minutes at some point11 to knock down 21 coconuts and replace the one lost to the fire . some economists would say Crusoe will “maximize his utility . he considers how his goals will be affected by those particular items .
Remember that with his pole. economists would say that on the margin the loss of a coconut is fairly insignificant .
Pulling It All Together: What Should Crusoe Do With Himself?
We’re finally ready to explain how Crusoe actually conducts himself . as he subjectively perceives them . that’s not the decision he faces as he runs out of the burning hut .
11
. He must also consider the costs . And as we’ve seen. which means he gathers 1 coconut every 12 minutes . because of the decision . that’s why it’s perfectly sensible for Crusoe to grab the watch. economists often drive home the point by using the longer term opportunity cost. the cost of a particular decision is the value that Crusoe places on the most important goal that he won’t be able to achieve. or that he’ll have to work a little more . he can’t simply consider the benefits. which he values for sentimental reasons . It is completely irrelevant to Crusoe that 100 coconuts are more valuable to him than 100 watches. When he is deciding how valuable a particular coconut is. he has to decide if one coconut is more valuable than one watch . Crusoe will make decisions in order to achieve his most important goals . In fact. no. In the language of economics. It simply means that Crusoe will have to eat a little less at some point. Crusoe will act to achieve his highest-ranked preferences. compared to a particular watch. Crusoe can gather 5 coconuts per hour. the loss of one particular coconut isn’t devastating at all .

He certainly had the option to calmly eat his last coconut before passing out from smoke inhalation . In reality. we wouldn’t be able to make much sense of Crusoe’s actual decisions . that he would thereby have to sacrifice because of his decision to grab the watch . “getting a few minutes more sleep . say. we looked at what the best option was. Without realizing the connections between his choices. we cheated a bit. when trying to understand the decision Crusoe really faced. That wouldn’t have been an accurate description of the true cost of his action. We knew that Crusoe would first and foremost choose to save his life by running out of the hut.”) And in that context. We said that he faced a choice. because “the joy of face pummeling” is presumably not high on Crusoe’s list of preferences . Or he could have picked up the coconut. we have been explaining the nature of the tradeoffs Crusoe faces in his daily decisions . we assumed that Crusoe’s next-best alternative was grabbing the coconut .12 the economist would explain Crusoe’s action in this way: Crusoe decided that the benefits of having the watch outweighed the cost of having one fewer coconut . Crusoe had all sorts of options at his disposal . he could have decided to use his hands to punch himself in the face . we knew that he faced the subsequent decision of grabbing just one item on his way out . For example. this is simply using different words to say: the goals Crusoe could achieve with
In other words. In our story. Crusoe would have chosen to rescue the coconut . because (we assume) he placed self-preservation very high on his list of preferred outcomes . But actually. (It was much much higher than. if the watch had already been outside. When we discussed Crusoe’s actions after he foolishly let his hut catch on fire.
12
. Rather than grabbing the coconut or watch. We didn’t bother comparing the benefits of rescuing the watch. let’s reconsider Crusoe’s actions as he ran out of the burning hut . we didn’t bother considering all of the silly possibilities just mentioned . we just took it for granted that Crusoe would leave the hut in the first place . Instead. versus the cost of not being able to punch himself in the face with two free hands . between grabbing a coconut or grabbing a watch .62
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up till now in this lesson. we zoomed ahead to what we knew the real tradeoff was . In fact. but then hurled it at the burning roof .

13 the last point in this lesson is that all of Crusoe’s actions are guided by his expectations. He thinks he will be able to use it to escape to the high sea. the benefits are (ultimately) the extra pleasure he will get from consuming more coconuts in the future . Crusoe might spend several weeks collecting branches and other materials.Lesson 4: “Robinson Crusoe” Economics
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a watch and 99 coconuts. he is really choosing the outcome that he expects will give him more benefits than costs . He very well could be mistaken . were more important to him than the goals he could achieve with no watch and 100 coconuts . Crusoe might decide to enjoy an extra hour of leisure . after many attempts. In this case. Crusoe realizes that the ocean won’t let him escape the island on his raft .) the cost is the value Crusoe places on the most important goal that he now won’t be able to achieve . When Crusoe makes a particular decision. suppose on his way to cut down more vines. the other decisions Crusoe makes are more complicated. (Remember that he needs the vines to maintain his pole in good condition. which is to say his predictions about the future . the benefits of this small chance of escape are more important to Crusoe than the leisure he is giving up during the construction of the raft . that means the cost of his original decision (to spend an hour cutting vines) was the value to Crusoe of having 20 hours of leisure that day. he can’t find anything on his island that would serve as a large sail . For example.
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Remember that Crusoe works the first four hours of the day gathering coconuts . He realizes with great regret that his efforts on the raft were a complete waste of time . he has 20 hours remaining in his day . Or more accurately. For example. it’s because he considers the benefits to outweigh the costs . but the basic principle is the same: Crusoe always chooses the option for which the benefits exceed the costs . the result of a freak lightning strike . Crusoe sees a pile of perfectly cut vines lying on the ground. instead of 19 . In that case. a complete waste of leisure . At that point. where he hopes someone will rescue him . in order to knock down coconuts . when Crusoe decides to work a fifth hour on a particular day. For example. in order to construct a raft . in order to gather more vines. If he works a fifth hour gathering vines. unfortunately. However. than he only has 19 hours remaining for leisure—and that includes sleep .

as economists we still explain his original choices by saying that Crusoe considered the benefits of getting out to sea to be greater than the cost of many hours of leisure .64
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Despite Crusoe’s mistake. Crusoe believed that it was. even though this wasn’t the true tradeoff involved.
. and it is ultimately Crusoe’s beliefs (and preferences) that guide his decisions .

• Economists say that an individual will engage in more and more “units” of an activity so long as the subjective benefits outweigh the costs. we can apply them to more complicated (and realistic) scenarios involving many people. After mastering the tools in a simplified setting. people sacrifice current enjoyments but achieve much greater enjoyments in the future.Lesson 4: “Robinson Crusoe” Economics
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Lesson Recap •••
• We can learn many basic economic concepts and principles by studying an imaginary “economy” consisting of just one person. Through saving and investment.
. • One of the most important decisions a person makes is whether to devote time and other resources to the present or to the future.

they are not direct gifts from nature . Disutility of labor: economists’ term to describe the fact that people prefer leisure to labor . Income: the flow of consumer goods and services that a person has the potential to enjoy during a specific period of time . Capital goods: Producer goods that are produced by human beings. as opposed to engaging in labor . Producer goods / factors of production / means of production: scarce physical items or services that indirectly satisfy preferences. Land / natural resources: Factors of production that are gifts of nature . Labor: the contribution to production flowing from a person’s body .
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new Terms
Economize: the act of treating a resource with care because it is scarce and can only satisfy a limited number of goals or preferences . Leisure: A special type of consumer good that results from using one’s body (and time) to directly satisfy preferences. People only engage in labor because of its indirect rewards . because they can be used to produce consumer goods and services . Consumer goods and services: scarce physical items or services that directly satisfy a person’s preferences .

Depreciation: the wearing away or “using up” of capital goods during the course of production . Marginal utility: A technical economics term referring to the subjective enjoyments of one additional unit of a good or service . (Opportunity) cost: the benefits of the next-best alternative to a given action . Investment: Diverting resources into projects that are expected to increase future income . often used in reference to labor . which involve his or her understanding of “how the world works” and therefore guide current actions . Expectations: An individual’s forecasts of the future.Lesson 4: “Robinson Crusoe” Economics
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Saving: Consuming less than one’s income would allow. Benefits: the subjective enjoyments flowing from a course of action . Productivity: the amount of output produced by a factor of production in a period of time. Equilibrium: A stable situation after all disturbances or changes have worked themselves out .
. living below one’s means .

How do expectations affect someone’s decisions?
. What does it mean to say Crusoe creates goods with his “mind powers”? 3. Why does Crusoe need to worry about depreciation of his capital goods? 5. Can leisure be more physically demanding than work? 4.68
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sTudy QuesTions
1. Does economics assume that people act in isolation from the rest of society? 2.

Part II
CAPITALISM: THE MARKET ECONOMY
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we’ve explained that economics studies exchanges. there’s a new wrinkle in our analysis: What happens when
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. economics will show us patterns that we could not have noticed in the simple Crusoe scenario . also known as a market economy. However. But in these more complicated settings. we defined some of the basic concepts of economics. and applied them to a hypothetical man stranded on a tropical island . and are just as applicable in a bustling metropolis as on Crusoe’s island . and that basic economics simply spins out the logical implications of purposeful actions .Lesson 5
The Institution of Private Property
In this lesson you will learn:
• The reason society requires institutions to deal with scarcity. once we move from an isolated person into a world of two or more people.
Society Requires Rules
o far in this book. In Lesson 4. • The three main institutional settings in which this book will apply economic analysis. • The essential features of a capitalist system. the laws or principles that we developed for our Robinson Crusoe are valid for everyone else.

so only Crusoe was evaluating the value of various units of coconuts. rocks. If a man sees a coconut. Given the physical realities of the island. In this book we will focus on three different institutions that humans have historically used to deal with the social conflict caused by economic scarcity . economics says that everybody else is doing the same thing . in order to improve its alleged shortcomings . For if that coconut is already part of someone else’s stockpile of savings. discovers the various exchanges that are available to him. Crusoe had the only intelligent mind. In addition to the tradeoffs and constraints imposed by nature. He looks around his environment. and proceeds to make those choices that give him the highest benefits relative to their costs . In society. Crusoe would give up five hours of his leisure every day. or what is called a market economy . in society there are the additional constraints imposed by everyone on each other . all of the physical items that can satisfy human goals are being appraised by millions of different minds . the economic problem of scarcity leads to conflict . a system in which the government owns all goods or at least all the producer goods . we will apply the insights of economics in the realm of capitalism. Yet at the same time. those were the “terms of employment” offered to Crusoe . he was “exchanging with” nature herself .72
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two people want to use the same unit of a good in incompatible ways? In the case of Crusoe. we will briefly explore the attempt to handle scarcity through socialism. the two people’s goals can’t both be achieved . In Part III. and in return nature would give him a daily stream of 20 coconuts . it’s not simply a question of whether it’s worth his effort to go grab it . In a large city. we could say that in a sense. and so forth . where the government actively interferes with a background market economy.
. the situation is the same when Crusoe gets rescued and returns to civilization . In this Part II of the book. All alone on his island. At an abstract level. we will use economics to analyze what happens in a so-called mixed economy. vines. And finally in Part IV. there aren’t enough units of goods to go around and satisfy everyone’s goals or preferences . For example.

the term “private property” sometimes means. —Frédéric Bastiat. goods and services are owned by individual private citizens.1
Property Is Fundamental
Property does not exist because there are laws.html
At least in the united states. But in terms of capitalism versus socialism. In a pure capitalist system. when a man spots a coconut. but laws exist because there is property. the owners of the mall have the legal right to boot you from their property . so in a capitalist system. but every tractor. A good’s owner is the person with the legal authority to decide how that good shall be used . sometimes organized in groups . “Keep out! Private Property. and assembly line are all respectively owned by private citizens. if you and your friends are loitering in the parking lot and harassing customers as they park. whereas the socialist system concentrates incredible power in the hands of the privileged elites . if you and your friends are wandering through the woods and come across a barbed wire fence with a sign saying . he isn’t (legally) allowed to consume it. In this institutional arrangement.
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. acre of farmland. or unless he gets permission from the owner . “Property and Law” (1848).” you probably don’t want to mess with the guy who posted the sign . “stay away!” For example. or by groups of such citizens . unless he is the owner. not only every house and car. A capitalist system is based on private property . who wanted to convey the idea that it was a system serving the narrow interests of the capitalists .Lesson 5: The Institution of Private Property
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Capitalism: This Is Private Property
the term capitalism was originally a smear used by Karl Marx. even the parking lot of a mall is “private property . the capitalist system showers wealth on all of its members.org/en/property_law. Of course. as we’ll see in later lessons.” the owner(s) of the mall are simply giving blanket permission for all potential customers to use their property while they browse . However. http://bastiat.

rather than political philosophy. Because this book is an introduction to basic economics. every major economy today has a public (government) sector .
The Market Economy and Free Enterprise
economists often refer to “the market” as if it were a being with an independent mind . there are no real-world examples of a pure capitalist system . there are no major economies today that even claim to operate under pure socialism .” —The Lord God. quoted in Exodus 20:15
In practice. police. At the same time. economists who are suspicious of political interference might say. For example. Other books can provide economic analysis to help you form an opinion as to the proper role for government to play in the provision of judicial. “the bureaucrats should mind their own business and leave these decisions to the market!”
. one in which all goods and services are privately owned and exchanged in the marketplace . Instead there is a spectrum of the relative scope of the government versus the private sector . since the fall of the soviet union. Political theorists and economists have argued extensively about the ideal position on this spectrum—including its two end points of pure capitalism versus pure socialism .74
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Don’t Take Our Word For It
“Thou shalt not steal. we will sketch the operation of a pure capitalist system. we will simply present sketches of three points on the spectrum: the two ends and the midpoint . We will simply assume that the participants in the market respect these property boundaries . In addition to its private sector. In this section of the book (Part II). and military services that might be necessary to sustain widespread respect for private property .

Finally. and try to outcompete them . And if he is to be a successful tailor. entry into the various professions was strictly regulated by guilds . workers are free to choose their employers—or to go into business for themselves—as a natural consequence of their ownership of their bodies . slavery forms no part of a pure capitalist system .” this is just shorthand for saying that the incentives in a society based on private property led individual teachers to choose to relocate to the particular town . For example. the crucial element of free enterprise is that there is no additional hurdle that the would-be tailor needs to jump over. but refers to interactions between owners of private property .
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However. “the market channeled more teachers into the town as its school-age population grew. or brain surgeons in a major city. the services performed by human beings are some of the most valuable items in the economy . this means that individuals (or groups of individuals) are free to enter any line of work they so choose . he will need to convince potential customers to voluntarily trade away their money in exchange for his products and services . When economists say things like. anyone who wants to enter a certain profession can do so . these items too must be assigned private owners . But in a market economy. Both for moral and practical reasons. the market or the market economy simply refers to the whole web of exchanges that individuals make with their private property . In medieval times. Whether we are dealing with Crusoe on his island. he needs to respect the private property rights of others: If he wants to operate out of a store. he needs to rent the space or buy it himself . but for now we should just be clear that “the market” is not a person or even a place. In a capitalist system. In subsequent lessons you will learn how these incentives operate in a market economy. People often describe a capitalist system as having free enterprise . Of course. all he needs to do is convince other private owners that they can all mutually benefit from dealing with him in his capacity as a tailor . Slavery occurs when some individuals have the legal right to the bodies (and the services they perform) of other individuals . we note that the most significant piece of property is your own body . someone couldn’t simply announce that he was a better tailor or carpenter than the other workers in town. In a market economy.

• A capitalist system. and avoid conflict over scarce resources. also known as a market economy. and a mixed economy. • This book will study the three institutional settings of capitalism. features private ownership in resources. People are free to choose their own occupations and start whatever business they want.
. but any resources the business uses must be purchased or rented from the owners. socialism.76
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Lesson Recap •••
• Society requires institutions to establish rules and procedures so that people can interact with each other peacefully.

Private property: A system in which resources are owned by people outside of the government . Capitalism: A economic system relying on private property and free enterprise . a grocery store is in the private sector .)
. (For example. the very wealthy capitalists exercise a large degree of control over businesses . the owner can usually transfer ownership to another person . Mixed economy: A system that allows private citizens to legally own resources. no single person or group controls the system as a whole . Socialism: An economic system in which government officials decide how society’s resources shall be used to produce particular goods and services . Capitalists: the people in a capitalist society who control (large amounts of) financial wealth . Private sector: the portion of an economy that is controlled by people outside of the government . but in which government officials lay down rules that limit the choices the legal owners can make with their property . Owner: the person who has legal authority to decide how a particular unit of a resource or good shall be used .Lesson 5: The Institution of Private Property
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new Terms
Institutions: social relationships and practices that allow people to interact with each other . Institutions provide a framework of predictability in society .

It also refers to the collection of voluntary exchanges that occur in a capitalist system . the local police station is in the public sector .) Market / Market economy: Can be a synonym for capitalism . (For example.
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Public sector: the portion of an economy that is controlled by the government . they don’t need special permission from anyone to enter an industry . A person who wanted to become a blacksmith or a carpenter would first need to be accepted by other members of the guild . Free enterprise: A system in which individuals can choose their own occupations and are free to start whatever business they wish . before the capitalist era . Guilds: the organization of occupations in the medieval period. Slavery: A system in which some human beings are considered the legal property of others .

What does it mean when an economist says. Did Crusoe need an institution of private property? 2. Is the sketch of a pure market economy a realistic depiction of the United States? 5. Why does economic scarcity lead to potential conflict in society? 3.Lesson 5: The Institution of Private Property
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sTudy QuesTions
1. “We should let the market decide”?
. What are the three main institutional settings we will study in this course? 4.

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but with another person . every “exchange” that he made with nature was designed to benefit himself . because individual trades are the building blocks of the entire market economy . to understand a market economy.
Why Do People Trade With Each Other?
n Lesson 4 we learned a lot about economics just from studying Robinson Crusoe and his “exchanges” with nature . For Robinson Crusoe. not with nature. the true meat of economics comes from studying trades involving more than one person . since we are assuming (in Part II of this book) a market economy with secure property rights.Lesson 6
Direct Exchange and Barter Prices
In this lesson you will learn:
• Why people trade with each other. we know that both people in a
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. • The definitions of direct exchange and barter. Crusoe only chose those alternatives where he judged that the benefits outweighed the costs . However. the same is true when a person exchanges. we need to first understand individual trades between two people. • How prices are formed in barter.

How can this be possible? some critics of capitalism think that if one person gains from a trade. both parties expect to walk away from the trade better off than they were before the trade . we will explain the principles behind exchanges that do not involve money . In a direct exchange. Our story of tina and sam involved direct exchange. maybe sam has too much acid in his system and eating the orange causes a burning sensation. sam will regret that he made the earlier trade with tina . For example. so long as the exchanges are voluntary and honest—in other words. both parties in a voluntary trade (expect to) benefit from it . We will actually explain these principles in the next lesson . and so forth . For most readers. yen.
. In other words. Very often people make mistakes in their forecasts of what will make them happy . It wouldn’t be strange if tina would prefer an apple to her orange. euros. this will mean explaining the prices of goods and services as they are traded against dollars. they can both be happier by trading . In that case. both parties have a “direct” use for the object that they are receiving in the trade . it must be at the expense of the other party. because each student wanted the other’s fruit in order to consume it . specifically. If sam and tina become aware of each other’s predicament. and sam comes to school with an apple . we will focus on (what economists call) direct exchange. so that he ends up throwing it out after two bites .
Direct Exchange / Barter
ultimately we want to explain exchanges involving money .82
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voluntary exchange expect the benefits of the trade to outweigh the costs . But these critics are wrong! Remember that preferences are subjective . so long as the exchanges aren’t forced or based on deception—people can achieve more of their goals by having the option of trading their property with each other . while at the same time sam would prefer an orange to his apple . even so. or what is also called barter . For the remainder of this lesson. suppose tina comes to school with an orange in her lunch. they believe that one man’s gain translates into another man’s loss . the important point for now is that at the moment of exchange.

and you don’t intend to combine it with other materials in order to build something . because he will mix them with other items (such as soil and fertilizer) in order to produce tomatoes in the future . is that you expect to be able to find somebody else (in the future) who will sell you something you do directly value. What happens in this case is that they plan on trading the item away to somebody else in the future .
Prices
In any market exchange. the familiar distinction between buyer and seller disappears. where both parties intend to use the traded objects for consumption or production (but not for a subsequent exchange) . Here. in exchange for the money . We only leave a state of barter and enter the realm of indirect exchange when people receive an item during a trade that they don’t plan on using themselves. Farmer Jones values the bacon as a consumption good. Don’t be confused: even though you might say that Farmer Brown doesn’t “directly” benefit from the tomato seeds. we are explaining direct exchange (or barter). When you sell a few hours of your leisure cutting your neighbor’s lawn for $20. Farmer Brown might give a pound of bacon to Farmer Jones. whether for consumption or production . In barter. the price is the ratio of those units . in exchange for a bag of tomato seeds . you are engaged in indirect exchange . Brown is
. this is actually what happens in every trade involving money . that means the buyer must give up 20 units of dollars while the seller gives up one unit of the DVD .Lesson 6: Direct Exchange and Barter Prices
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Direct exchange (or barter) can involve not only consumption goods. You don’t plan on eating the $20 bill.) For example. (Refer back to Lesson 4 if you don’t remember the difference . he will fry it and eat it that morning for breakfast . the reason you value it. if the price of a DVD is $20. For example. they are a producer good for him. but also producer goods . when Farmer Brown gives a pound of bacon to Farmer Jones in exchange for (say) 100 tomato seeds. units of one good (or service) are traded for units of another good (or service) . For example. But Farmer Brown doesn’t want to eat the tomato seeds he got in exchange! no. We will develop the theory of indirect exchange in the next lesson . because there is no money . the trade still counts as “direct exchange” (or barter) because both farmers want to personally use the items they receive in the transaction .

In other words. but just to know that they can do so. Billy. and because of their different tastes. if there are 20 different types of goods that all trade against each other. with every good (and service) having an entire list of exchange rates with every other good (and service) in the economy . We explore this topic in the next section . part of the beauty of a monetary economy is that we don’t need to use barter prices. the idea is simply to give you a concrete example to make sure you can visualize the more general principles . Jones is the opposite: a buyer of bacon and a seller of seeds .) We can also say that the price of a pound of bacon is 100 tomato seeds. and that the price of a tomato seed is 1/100 of a pound of bacon . they each start with different amounts of snickers and Milky Way candy bars .
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. For example. we need to first understand the more general case of barter . But before we can explore (in the next lesson) the special case of how prices are formed when money is involved in every transaction.
How Prices Are Formed in Barter
For the remainder of this lesson.1 Our example revolves around three siblings—Alice. But if there is one type of good involved in every trade— and that’s precisely what money does—then the trader only needs to keep track of 20 prices: the exchange rate of each of the 20 goods against units of money . because of their different holdings. (Of course.84
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simultaneously a buyer of seeds and a seller of bacon . we will work with a specific numerical example to illustrate why specific prices occur in barter exchanges . if they know the preference rankings of the potential traders (and make a few assumptions) .
You may find some of the material in this section too difficult to fully understand . If that is the case. the important take-away message is not for you to know exactly how economists can explain actual barter prices. the children will be able to reap gains from trade . or barter prices . As we will see in the next lesson. Of course there is nothing magical about the numbers we will choose. then a trader in a pure barter economy would (in principle) need to keep track of (20x19)/2=190 different exchange ratios. As we will see. just read it and absorb as much as possible . and Christy— who arrive home on Halloween after an evening of trick or treating .

It’s true that if Alice initially has zero of each candy bar. she would prefer to receive a snickers over a Milky Way . Now if someone offers her a choice between an (additional) snickers versus a Milky Way. the table below tells us this. and if she has to choose just one. she basically likes snickers more than Milky Ways. above the combination (0 snickers . the following table represents Alice’s preferences. she
. or rankings. while the combination (1 snickers . For example. if Alice initially has no snickers or Milky Ways. However. A third possibility is having 1 snickers and 2 Milky Ways . 1 Milky Ways) which is ranked in second-last place . that means there are 25 possible combinations each child could have. And so on. 0 Milky Way) coming in at a lowly 21st place . for all 25 possibilities . A second possibility is having 3 snickers and 0 Milky Ways . she will choose the Milky Way . In our hypothetical example. to keep things manageable. 0 Milky Ways) has the lowest ranking. of various combinations of snickers and Milky Way bars . because the combination (0 snickers . we’ll first need to come up with a convenient way to represent the information . it’s important for you to remember that people value goods unit by unit (or “on the margin”) . We have constructed Alice’s ranking to be systematic. In other words.) Before proceeding. or (equivalently) a specific “Milky-Wayprice” of snickers . However. this is because Alice ranks the combination (1 snickers . 0 Milky Ways) is ranked at 23rd. (One possibility is having 4 snickers and 4 Milky Ways . in our example . suppose that Alice already starts out with 1 snickers bar . we want to ultimately show why a specific exchange rate between snickers and Milky Ways emerges . But notice that Alice also prefers variety . In order to work through the example. we want to understand how the children’s initial holdings and their preferences will lead to a specific “snickers-price” of Milky Ways. which is well above the combination (2 snickers . she will pick a snickers .Lesson 6: Direct Exchange and Barter Prices
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through voluntary exchanges. and she also prefers to have more candy rather than less . the children will all walk away from their small “market” happier than they entered it . 1 Milky Way) in 17th place. we will only consider cases where the children can have at most four of each type of candy bar .” For example. let’s make sure you understand the information in the table on the next page . We have chosen the numbers so that there is a definite sense in which Alice “likes snickers more than Milky Ways .

let’s assume that they won’t be splitting candy bars. because the children start out with different combinations. people aren’t identical copies of each other. especially when their preferences can encompass not merely 25 different scenarios. but an enormous number of combinations of many different goods and services . Just as we can’t say that people value water more than diamonds. A simple inspection of their rankings reveals that there are gains from trade . of course. you will see the patterns in her preferences . they come home from trick or treating with different collections . while her brother shows up with 0 snickers and 4 Milky Ways . by rearranging their property. Given the information in the table.” but we picked the commonsense ranking above to make it easier for you to follow the example . Although the children have the same tastes for various combinations of snickers and Milky Way bars. we can add her brother Billy to the mix . to repeat. there are still gains from trade . If you spend a few moments studying the table above. In the real world. In the real world. so there is nothing odd or “irrational” about Alice preferring the combination of 1 bar of each . in order for you to see the effects of the children starting with different combinations of candy bars . to keep things simple. It all depends on how many units of each good Alice starts out with when she is faced with a specific decision . economic logic alone can’t tell us the exact terms on which Alice and Billy will agree to their exchange . Alice comes to the bargaining table with 4 snickers and 0 Milky Ways. However. what can we say about their trading?
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all snickers . people’s preferences don’t mechanically obey a simple set of “rules. We’ll suppose that his tastes are identical to Alice’s . this information (and more) is summarized in the following table . However. by the same token we can’t really say that Alice values snickers (or more candy bars) more than she values Milky Ways (or fewer candy bars) . we have purposely chosen Billy’s preference rankings to be identical to Alice’s. now that we understand Alice and her preferences. In other words. so that they can only trade whole bars . Alice and Billy can both end up with a snicker-Milky Way combination that each subjectively prefers to the combination he or she started with .

A similar analysis holds for Billy . He could move from the 18th ranked combination up to the 13th by trading away 1 Milky Way for 1 snickers . Alice wouldn’t give up a third snickers to acquire yet another Milky Way. and then they pause to reevaluate . so the question is: Would Alice be willing to trade away one or more snickers bars. Or you can imagine Alice offering 2 snickers right off the bat. because that would move her back down to the 13th ranked combination ( 1s .” suppose that Alice and Billy trade snickers for Milky Ways at the ratio of 1:1 . in exchange for Billy’s 2 Milky Ways .Lesson 6: Direct Exchange and Barter Prices
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Alice ending up with any of the combinations ranked 17th through 25th on her preferences. For our current lesson. then the only stable stopping point—the only equilibrium position—occurs when Alice and Billy have rearranged their candy bars so that they both end up holding 2 of each kind . and moving up to the 11th ranked outcome on his own preferences . and so each sibling will end up at least as happy after trading as he or she was before trading . Because our example is so simple. she starts in the 16th-ranked cell. 0 Milky Ways ) . You can imagine Alice first giving Billy 1 snickers in exchange for 1 of his Milky Ways. she could trade away 1 snickers for 1 Milky Way. Are there mutually advantageous trades at this price? Let’s look at Alice’s preferences first . But she could do even better still by trading another unit. 1M ) combination ranked in 12th place . we can pretty quickly run through the possible trading outcomes by experimenting with various “prices . in exchange for an equal number of Milky Ways? We can see that the answer is yes .
. and we can rule out Billy ending up with a candy combination ranked 19th through 25th on his preferences . Be careful! It may seem as if we just “proved” that Alice and Billy will each end up with 2 of each candy bar. there are other prices that would still allow them to make mutually beneficial trades . It is always an option to refrain from trading and just eat the candy they personally acquired from trick or treating. and moving up to the 11th ranked combination of two of each candy bar . with ( 4 snickers . the important point is that if we set the price at 1:1. we will not delve too deeply into the exact procedure Alice and Billy use when bartering . But he could do better still by trading an additional unit. and end up with the ( 3s . 3M ) . but we’ve only showed that this is the logical stopping point if they trade snickers for Milky Ways at a 1:1 ratio (price) .

and so Billy could never push through such an offer . notice that even though the price ratio 1:3 works. suppose Alice says to Billy. On the other hand. He would end up with 1 snickers and 2 Milky Ways. there is yet a fourth possibility . From analyzing Billy’s point of view. take it or leave it . for the hypothetical price ratio of 2 snickers for 1 Milky Way .90
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For example.
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. an outcome that is ranked three slots higher than if he doesn’t trade at all . this too is a possibility—if Billy really believed this to be the “going price. we know that that won’t occur .
Alice would also want to engage in a further trade on these terms. “I will give you 1 of my snickers bars if you give me 2 of your Milky Ways . a movement back down his preference ranking . the opposite does not: Alice would rather keep her original combination than give up 3 snickers for 1 measly Milky Way. or else he would take his Halloween loot to his room and slam the door . Billy could have issued a comparable ultimatum to Alice.” Is this a good deal? It’s certainly a good deal for Alice . It would allow her to end up with 3 snickers and 2 Milky Ways. If Alice believed his threat. because then he would be left with ( 2s . the dark gray cells in the table above indicate the final combinations at a price of 2:1 . the 7th most valuable combination on her ranking . if we continue to assume that the children only trade whole bars for each other . moving her to the 6th most preferred combination of having 2 snickers and 4 Milky Ways . But he wouldn’t engage in the same trade a second time. that’s the only trade I am willing to make .2 the trade would also make Billy better off . suppose Alice is particularly cutthroat and demands 3 Milky Ways in exchange for just 1 of her snickers . saying that he would give up 1 of his Milky Ways in exchange for 2 of her snickers. since Alice can only partially complete her desired transactions at this price . As the white cells indicate.) this complication will make more sense to you after you study supply and demand curves in Lesson 11 . some economists might say that therefore the price ratio of 1 snickers for 2 Milky Ways doesn’t lead to a true equilibrium. You can check to see that there are no other prices that work. she could improve her position by accepting the deal . 0M ).” he would improve his lot by moving from the initial 18th position to the 17th position . (similar reasoning applies to Billy.

we would say that this isn’t an “equilibrium” outcome. suppose Alice says. the actual outcome will depend on factors beyond the simple preference rankings and initial distribution of candy . In the real world. then perhaps the even split will occur . look at the table below. so take care not to wrap too much significance around the economic concept of equilibrium—in the real world. if Alice and Billy are equally skilled in the art of negotiation. or 1:3 . even if the table above correctly describes their preferences and candy holdings . if Alice really “drives a hard bargain” and Billy is relatively meek. economic logic alone can’t tell us—with these specific numbers—how many candy bars Alice and Billy will have when they walk away from their trading session . the above example laid out some basic principles in understanding how prices are formed in a barter market . On the other hand. what have we learned? We have seen that the underlying preference rankings and initial combinations of candy bars allow us to identify four different stable resting points. In terms of our analysis. it’s certainly possible that Alice storms away. my best offer is to trade bars 1-for-1 . there is a different price .” In this case. or equilibrium positions . Another way of describing our results is to say that we have identified four different outcomes in which the gains from trade would be exhausted.” Yet Billy thinks she is bluffing and says. For this new twist. disequilibrium occurs all the time!
Collapsing the Scope of Prices By Adding More Traders
Despite the complications. 2:1. “Give me 2 Milky Ways and I’ll give you 1 snickers bar. it’s possible that Alice and Billy make no exchanges. We can’t say for sure whether they will trade snickers for Milky Ways at a ratio of 1:1. “nope. or else I walk .
. making good on her threat . because there are still gains from trade that remain to be exploited—Alice and Billy can still both be happier if they swap their property around . For example. In this final section we’ll show that adding another trader can knock out some of the original possible prices . We also pointed out that for each of these four positions. then it’s likely that she will push through the trade of 1 of her snickers in exchange for 2 or 3 of Billy’s Milky Ways . 1:2.Lesson 6: Direct Exchange and Barter Prices
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summing up.

she would be willing to give up 2 of them to acquire 2 Milky Ways. you know that there are situations where Christy would give up snickers bars to obtain Milky Ways . Christy would love to participate . we’re going to look for outcomes where there is only one price for all the trades. let’s lay the ground rules of how we’re picturing the negotiating process . other things equal . Christy prefers more candy to less. and she also enjoys variety.” In the previous section we saw the various possible outcomes and barter prices with just Alice and Billy .)
. However.” For example.) Of course. 7th. We are also going to rule out any trade in which one of the children would object and make a better offer to one of the parties . Christy might say. as someone trained in economic thinking. “Christy does not like Milky Ways nearly as much as the others do . Like them.” or perhaps. For example. it is easy to see what the average person would mean by saying “Christy likes snickers more than the others do. if she started with 4 snickers. we already determined that Alice and Billy would each end up with 2 of each type of candy bar . in other words Alice can’t charge Christy more Milky Ways than she charges Billy . What happens if Christy comes to the bargaining table before any deals are struck. to keep things as simple as possible. At the price of 1:1. For example. But looking at her preference ranking compared to Alice's or Billy’s. and she’s carrying 1 snickers bar and 4 Milky Ways? Before starting the analysis. If Christy had never shown up. some of the possible “equilibrium positions” we discussed earlier break down . suppose Alice and Billy are about to trade snickers for Milky Ways at a 1:1 price ratio . in everyday language people would say that Christy “likes snickers bars a lot more than Alice and Billy .” (these successive trades would move Christy from her original 13th ranked combination up to the 9th. as her 11th and 12th rankings demonstrate . so when Christy enters the scene. After Billy and Alice had swapped 2 snickers for 2 Milky Ways. and 6th ranked combinations . I would like to trade up to 3 of my Milky Ways for 3 snickers bars from either of you guys . Christy would rather have a single snickers bar than have 4 Milky Ways! (Look at her 20th and 21st rankings . “OK great.Lesson 6: Direct Exchange and Barter Prices
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notice that Christy’s preferences for candy bars are not the same as Alice's and Billy’s .

the other two price ratios “survive” the arrival of Christy . Christy remains a bystander .94
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When Alice and Billy replied that they had done all the trading they wanted at the 1:1 ratio. she wouldn’t be willing to trade him her sole snickers for only 2 Milky Ways . so we see that 1:3 is still a stable or equilibrium price. if the price ratio of 1:1 occurred and Alice and Billy traded according to the original outcome when it was just the two of them . suppose Christy comes on the scene and observes that Alice is going to trade 1 snickers for 2 of Billy’s Milky Ways . “Can you do better than Alice?” Christy answers no. Alice might ask Christy. In this final scenario. 4M ] for Christy . while Billy ends up in his 15th position and Christy in her 11th position .” but Christy would decline this offer too . “Why in the world did you trade away your snickers at such a low price?! I would have gladly given you twice what Billy did . At that price: (a) Alice sold 2 snickers and bought 4 Milky Ways. similar reasoning “knocks out” the other (original) stable outcome where Alice offered 2 snickers to receive 1 Milky Way .” For the purposes of our analysis in this lesson. Christy would be heartbroken . but one on which Christy is content to “stay out of the market” and just eat the candy she personally collected from trick or treating . (We haven’t included it because of space constraints. after the swap with Billy went through. “I’d be willing to give up another of my snickers for 3 of your Milky Ways. she sees Alice propose 1 of her snickers for 3 of Billy’s Milky Ways . Once the candy bars have been rearranged in this fashion. After the trades are complete. there is a sense in which Alice and Christy would both regret the outcome. He is tempted by the offer—it’s better than nothing—but he turns to Christy and asks. the “equilibrium price” was 1 snickers for 2 Milky Ways . we are going to say that this type of situation does not form a stable outcome or equilibrium . she could explain to Alice. Loosely speaking we say that Christy comes on the scene and “knocks out” the 1:1 price . the really interesting scenario is the price ratio of 1:2 . there are no more gains from trade . (b)
.) Likewise. “I’ll take a piece of that action!” and Alice would be happy to oblige her . It would be crazy for Alice to trade with Billy at such a disadvantage. 6M ] would be ranked far below [ 1s . At the 1:3 price. Alice ends up in her 6th ranked position. Christy could say. when Christy would make her a much better offer . but the combination [ 0s.

there is a very narrow range of potential prices that are stable in the sense we’ve discussed above . after we introduce money and focus on supply and Demand in markets . For simplicity we will normally just talk of “the” equilibrium price.3 As with the analysis when there were just two children. Intuitively. meaning that she would have preferred another round of trading in the gray equilibrium . and the same for Milky Ways . We focused on important principles that will show up in later lessons. Alice could very plausibly prefer a combination of ( 2s . Generally speaking. 3M ). as determined by the preferences and initial property holdings of all the traders in the market . Although we didn’t show it because of space constraints.
On this point we again have to be careful because Alice can only partially complete her desired trades for the price of 1 snickers for 3 Milky Ways . Christy showed up with a large supply of Milky Ways and a strong demand for snickers. We went through the Halloween story in the present lesson to show you the basic foundation on which the more standard presentation— with supply and demand curves measuring prices in dollars—is based .
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Billy sold 2 Milky Ways and bought 1 snickers. Also notice that at the equilibrium price. in a large market with many buyers and sellers. and that ruled out some of the possible prices where snickers were fairly cheap (namely 1:1 and especially 2:1) . every child is able to complete the trades he or she wanted . Obviously the Halloween example was unrealistic in many ways. What we can say is that—with these specific numbers—Christy’s presence collapsed the possible range of prices . 6M ) to ( 3s . and (c) Christy sold 2 Milky Ways and bought 1 snickers . and there were many real-world considerations that we ignored .

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Lesson Recap •••
• People trade with each other because they expect to gain from the exchange. Trade leads to a win-win outcome. both parties expect to benefit. • So long as a trade is voluntary and honest. he can describe how they would settle on the terms of their exchanges. • If an economist knows the preference rankings of a group of potential traders.

Equilibrium position: A stable situation in which there are no further gains from trade . but instead will trade it away in the future to get something else . Gains from trade: A situation in which two people can both gain (subjective) benefits from swapping their property with each other . meaning how many units of one item are given up to acquire a unit of a different item . Indirect exchange: trading that occurs when at least one of the parties accepts an item that he or she does not intend to use personally. Disequilibrium: An unstable situation in which at least two people stand to benefit from an additional trade . Direct exchange / barter: trading that occurs when people swap goods that they directly value . Price: the terms of a trade.
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new Terms
Money: A good that is accepted by everyone in the economy on one side of every trade .

how many independent price ratios would exist? (E. *In what sense did Christy’s arrival “knock out” some of the possible equilibrium prices that could have formed between Alice and Billy?
. does that mean she would always choose a Snickers over a Milky Way. bananas. *If a producer good only provides benefits indirectly.98
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sTudy QuesTions
1. the apple:orange ratio would not be independent of the orange:apple ratio. In barter. and grapes. can a producer good be obtained via direct exchange? 3. If Alice likes Snickers more than Milky Ways..) 4. Suppose the economy has only four goods: apples. How is it possible for both parties to benefit from the same exchange? 2.g. if offered a choice between one or the other? 5. oranges.

Lesson 7

Indirect Exchange and the Appearance of Money

In this lesson you will learn:
• The limitations of direct exchange. • The advantages of indirect exchange and money. • The origin of money.

The Limitations of Direct Exchange

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n Lesson 6 we learned the tremendous benefits of direct exchange . Because people often have different tastes (or preferences), and because they often start out with different amounts of various goods, there are gains from trade . People can voluntarily trade their property amongst each other, so that everyone ends up owning property that he or she values more than the original collection of property .

However, even though direct exchange benefits everyone who participates in it, there are limits to its effectiveness . In fact it’s hard to imagine a world where people only engaged in direct exchange, versus indirect exchange (which we’ll discuss in the next section) . But in order to see the important difference, let’s just imagine a world where people only make direct exchanges .

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Remember, in a direct exchange each person must directly want to use the object being acquired . so we rule out any case where someone trades away something he originally owns, in order to acquire something that he then intends to trade away to yet a third person . It turns out that this limitation it actually quite restrictive . For example, suppose a farmer goes into town to get his tattered shoes repaired, and to buy a new shirt . He brings with him several dozen eggs hoping to make a trade . Our poor farmer has to not only find a cobbler with the necessary skills to repair his shoes, but he needs to find a cobbler who is that very same day looking to acquire eggs . the same is true of our farmer’s efforts to acquire a new shirt . He needs to find somebody who has a shirt that the farmer likes, and who is willing to trade away the shirt in exchange for the farmer’s eggs (at an acceptable price) . But if you think things are tough on our farmer, they’re even worse for the guy whose business is to produce stagecoaches . When he takes a finished stagecoach to market, he expects to get a large variety of goods and services in exchange for such a prized item . But if the world were limited to direct exchange, he would be unlikely to find a suitable trading partner . not only would he have to find someone who owned an acceptable collection of meats, eggs, shirts, milk, ammunition, etc . that our manufacturer preferred to his stagecoach, but that special person would also have to be “in the market” for a stagecoach . What are the odds of that? In reality, there would not be stagecoach producers, and probably not even shoe cobblers, in a world limited to direct exchange . People would not be able to specialize in certain professions, because it would be too risky . For example, a schoolteacher might instruct children in arithmetic and grammar, in exchange for milk, bread, and kerosene that the parents of the various children were willing to provide . But if one year there happened to not be any butchers who had school-age children, then the schoolteacher would have to go without meat the entire year! so we see that in a world of direct exchange, people would probably live basically as Robinson Crusoe . As a default, they would have to provide for their own range of needs directly, acquiring their own food, making their own clothes, building their own shelter, and so on . their standard of living would be much higher because of the benefits of trading with each other,

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but intensive specialization and large-scale production operations would be infeasible .

The Advantages of Indirect Exchange
We have seen the limitations of direct exchange . these limitations can be overcome when people begin to use indirect exchanges . In an indirect exchange, at least one of the traders gives up his own goods in return for something that he plans on swapping away for something else in the future . Once we allow this possibility, the limitations of direct exchange fall away . For example, recall our farmer who went to town with a few dozen eggs, seeking shoe repair and a new shirt . suppose the only cobbler in town told him, “sorry I don’t need any eggs right now .” under direct exchange, that would be that . However, with the possibility of indirect exchange, the farmer can ask, “What would you be willing to trade away your shoe repair services for?” suppose the cobbler answered, “I would fix your shoes if you could give me at least 6 pounds of butter, or 4 loaves of French bread, or a pound of bacon . those are the things I’m really interested in right now .” this holds out hope for our farmer . He can now walk around town (in his tattered shoes) looking for someone who wants eggs, and is willing to trade butter or French bread or bacon for them . Instead of needing to find the perfect match—a cobbler who was looking for eggs that very day—the farmer can now add three more potential candidates who will work . In fact, depending on how much time he wants to spend on the project, the farmer can take things a step further . suppose he finds a butcher who has extra bacon that he’s trying to sell, but that the butcher (like the cobbler) isn’t interested in any more eggs that day . the butcher mentions that he does want some fish . A few minutes later, the farmer meets up with a fisherman just back from a long haul, and who is dying to have a big omelet . If you have ever dabbled with role-playing computer games, we don’t need to spell out the opportunity this presents to our farmer . under direct exchange, the farmer needed to find a perfect match, namely a cobbler who wanted his eggs . Indirect exchange opens up a vast new range of beneficial trades, especially if traders are willing to operate

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at several “levels deep” of indirectness . the tremendous advantage of indirect exchange is that it facilitates rearrangements of property among multiple individuals, making them all better off, even though any single swap would have been vetoed by one of the required parties . the following diagram illustrates:

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Rankings for Direct Use
1 2 3

Cobbler
Bacon Leisure eggs

Farmer
Repaired shoes eggs Bacon

Butcher
eggs Bacon Repaired shoes

to keep things simple, in the diagram above we’ve left out the fisherman; we’re assuming the farmer was able to find a butcher who wanted eggs in exchange for bacon . As the diagram indicates, all three of the men are happier when (1) the cobbler repairs the farmer’s shoes, (2) the farmer gives his eggs to the butcher, and (3) the butcher gives his bacon to the cobbler . We know they’re all better off, because they’ve moved from their 2nd ranked positions up to their 1st ranked positions . (their original possessions are highlighted .) However, notice that under direct exchange, this beneficial rearrangement of property (and performance of services) could not have occurred . We already know from the original story that there are no direct gains from trade between the cobbler and farmer; the diagram above reflects this fact, because the cobbler values his leisure time more than the eggs the farmer has to offer . the diagram also shows that the butcher values his bacon more than having the cobbler repair his shoes, and so there are no gains from direct exchange between those two . Finally, there are no direct gains from trade between the farmer and butcher, because the farmer’s direct desire for bacon is ranked 3rd . If the farmer and butcher were the only people involved, then the farmer would not agree to the trade . the beauty of indirect exchange is that it allows universally beneficial property (and service) transfers to get around the “bottlenecks” imposed by direct exchange . As the case of our hypothetical farmer illustrates, indirect exchange allows everyone to move much higher on his or her preference ranking, through suffering a temporary “hit” that is made up in the future by trading away the (directly) inferior object . When it comes to advantageous rearrangements of property, indirect exchange facilitates the principle of “one step back, two steps forward .”

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The Advantages of Money
We have seen the advantages of direct exchange, and the even greater advantages of indirect exchange . However, even if people begin accepting items in trade, planning to trade them away for what they ultimately desire, this process can still be quite cumbersome . to see why, just recall our illustration of the farmer with tattered shoes: even though it all worked out in the end, he still had to go traipsing through town, looking for someone who was selling the items that the cobbler wanted to buy . Besides the physical exertion involved, we should also point out the mental effort that traders would have to waste keeping track of dozens or possibly hundreds of important price ratios . For example, let’s revisit our story of the farmer trying to find a buyer of his eggs so that he can give the cobbler enough bacon to fix his shoes . In the version of the story we told above, we simply assumed that once the farmer had run across the fisherman, that would be the end of the matter . Yet in reality, our farmer may have held out for a better deal . If the fisherman were willing to trade 3 fish for 6 eggs, and the butcher were willing to trade a pound of bacon for 3 fish, then the farmer would realize, “Okay, I can ultimately get my shoes fixed by giving up 6 of my eggs .” If this were his only option, the farmer would think it well worth the price . But what if the town were quite large, with many different merchants and professionals? suppose the farmer could find a baker who would be willing to give up 4 loaves of French bread for only 5 eggs . In this case, our farmer would realize, “Okay, I can ultimately get my shoes fixed by giving up 5 of my eggs .” notice that this is 1 egg cheaper than going through the route of trading eggs for fish . Already you are probably getting lost in all the details . Yet in the real world, people would start keeping track of the exchange ratios of various goods against each other, in order to know whether they were getting a “good deal” on any particular trade . We see that the possibility of indirect exchange is thus a blessing and a curse: It’s a blessing because it allows many people to make complicated (yet unanimously beneficial) rearrangements of their property . But it can also be a curse because people now can’t merely consult their preferences of the direct use of goods when deciding

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whether and how much to trade . Before giving away something that they might personally find revolting, they first have to ask, “How much could I get for this if I held out for another buyer?” What makes the above question particularly difficult is when traders need to reason two, three, or even more steps ahead to discover the ultimate “price” of the object they are trying to buy . In our story of the farmer, look at how complicated things got, even after introducing just a handful of different traders and their offers . In theory, for our farmer to be sure he obtained the cobbler’s shoe repair services at the lowest possible price (measured in eggs), he would need to survey the entire town, writing down everyone’s willingness to buy and sell various types of goods against each other . then he would need a math whiz to help him solve a complex problem, showing him the (perhaps very long) chain of individual trades through which our farmer could give up the least possible number of eggs, in order to ultimately acquire 6 pounds of butter, 4 loaves of French bread, or 1 pound of bacon (which the cobbler insists on before repairing the shoes) . Of course, in the real world we don’t have to go through such mental gymnastics every time we want to trade . Instead, we use money, which we can formally define as “a widely accepted medium of exchange .” In plain language, money is a good that stands on one side of (virtually) every transaction . Rather than trading other goods directly against each other, people first sell all their wares to obtain money, and then they use the money to buy all their desired items . When people in a community use money, they retain all the advantages of indirect exchange but considerably reduce its disadvantages . Rather than keeping track of dozens or even hundreds of price ratios of various goods offered and sought by various people, with money traders can simply keep track of the highest and lowest prices—quoted in money—of the items in which they’re interested . For example, if the town in our story above uses silver as its money, our farmer with the tattered shoes now has a relatively simple task . When he gets to town, he first searches for the person who will offer the most ounces of silver for his eggs . then with the silver in hand, the farmer searches for the person who will repair his shoes for the fewest ounces of silver . so long as everyone in town buys and sells using silver, the above procedure ensures that the farmer obtains his shoe repair (and whatever else he wants

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to acquire) at the lowest possible sacrifice of his eggs . He no longer needs to write down the desires of every person he meets—he frankly doesn’t care what others want to buy—and he no longer needs a math whiz to solve a complicated optimization problem .1

Who Invented Money?
the short answer is, “no one .” As with a dirt trail through a forest, the english language, rock & roll, the rules of chess, and hairdos in the 1980s, no single person got up one day and invented money . Instead, money arose gradually over time as a cumulative result of the actions of many people . the institution of money is a classic example of what Austrian economist Friedrich Hayek called a spontaneous order, meaning that the use of money is a very complex and useful practice, even though it was not consciously planned by an expert or even a group of experts . Quoting the scottish moral philosopher Adam Ferguson, Hayek described spontaneous orders (including money and spoken languages) as “the product of human action but not of human design .” today almost everyone on the planet thinks of money as pieces of paper issued by governments . However this was not always so . Historically, money arose first in the marketplace, as an outgrowth of voluntary exchanges between regular traders . Kings and other political rulers saw the spoils to be reaped and gradually took over this market-created institution, as we will explain in greater detail in Lesson 21 . But without the intervention of a wise king, how could society have adopted the use of money? How would everyone decide what to use? After all, researchers tell us that throughout history different cultures have used all sorts of things as money: sea shells, rocks, cattle, salt, tobacco, gold, silver, and even cigarettes (in World War II P .O .W . camps) . How would a group of people settle on a particular commodity to use as their money without resort to a political process?
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strictly speaking, the astute trader would keep his or her eyes open for an

arbitrage opportunity, even in a monetary economy . Yet even here, the calculations

would be much easier than in an economy with no single medium of exchange lying on one side of each transaction . One of the exercises in the teacher’s Manual spells out this difference .

and (4) convenient market value . the fisherman had a potential customer in the form of the farmer. caviar. we can list some of the practical considerations. etc . When we consider these four criteria. while other items (telescopes. notice that from the perspective of the fisherman and the butcher.) would be widely desired in trade. such as (1) ease of transport. etc .Lesson 7: Indirect Exchange and the Appearance of Money
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the answer is that it was probably a natural outgrowth of the efforts of people like our hypothetical farmer looking to get his shoes repaired . Popsicles also wouldn’t stand the test of time as money. in order to trade the bacon for a shoe repair . Recall that even though the farmer didn’t directly have any use for fish or bacon—he didn’t go to town to get either of those items—he ended up trading away his eggs for some fish. cattle are not very practical as money because they make smelly messes. (2) divisibility. eggs. then as the advantages of indirect exchange become obvious to more and more people. the initially more marketable goods would see a huge leap in their marketability . that means a trader would need to carry a lot more bronze in his pockets
. harpsichords. bronze has a much lower market value . Finally. If the snowballing process ever reached a point where a particular good were accepted in trade by almost everyone in the community.” to understand why some goods historically became money. but because it is so plentiful. For example. and you can’t simply cut a steer in half to “make change” during a transaction . and others did not. because they would know it would be easy to trade them away for whatever they ultimately desired . this process could snowball . a metal like bronze shares many of the excellent money-qualities of gold and silver. because they melt without proper care . when people were bartering goods against each other in a state of pure direct exchange. even those people who didn’t initially want the (highly marketable) goods for their direct use would nonetheless be willing to accept them in trade.) would be accepted by very few people . salt. In other words. certain items (chickens. that would mark the birth of money—“a widely accepted medium of exchange . In the beginning. in addition to all the people who wanted to buy fish for their own direct use. (3) durability. they saw an increase in the market for their products because of indirect exchange . who wanted to use the fish indirectly as a medium of exchange . they take up a lot of space. we see why gold and silver have proven to be such excellent candidates of market-based money . in order to trade the fish for bacon.

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(or in a cart) when making an expensive purchase. traders will end up adopting the money or monies that best suits their needs . compared to how many gold and silver coins or bars he would need for the same trade . historically. gold and silver have so often been adopted by sophisticated merchants as money . or that they are the only “natural” form of money .
. there is nothing in economics that says gold and silver must be money. In a voluntary market. We are merely explaining why.

” out of people’s actions to improve their trading positions using indirect exchange. Indirect exchange eventually leads to the use of money. • Nobody invented money. More complicated rearrangements of goods can occur. which make every participant better off. almost “by accident. • Indirect exchange expands the opportunities of mutually beneficial trades. This limitation would make it very difficult for people to specialize in occupations: A dentist who wanted meat would need to find a butcher who had a toothache. it is limited because a trader needs to find someone who has the desired item and who wants to accept the good that the first trader wishes to give up.
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Lesson Recap •••
• Although direct exchange is useful because it allows for win-win trades. It arose spontaneously. which makes it much easier for people to plan their trading activities.

the style of clothing that characterized the 1970s disco clubs.)
. Every indirect exchange requires a medium of exchange. the medium will usually be the air. In economics jargon. but because he or she wants to trade it away in the future to acquire something else. and the use of money . but it can also be water if you are in a pool with your head below the surface . not because the
person receiving it wants to directly use it. When it comes to sound waves. Medium of exchange: An object that is accepted in a trade. sound waves require a medium to travel through. examples would include the rules of grammar in the english language. Spontaneous order: A predictable pattern that is not planned by any one person . (Likewise. in order to reach your ears . which is the good through which the ultimate trade occurs . it is a widely (or universally) accepted medium of exchange .110
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new Terms
Money: A good that is accepted by everyone in the economy on one side of every trade . Arbitrage opportunity: the ability to earn a “sure profit” when the same good sells at different prices at the same time .

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sTudy QuesTions
1. Why would specialization be impractical in a world limited to direct exchange? 3. What are the disadvantages of indirect exchange without money? 5.
. two steps forward”? 4. *Describe a society in which the people practice indirect exchange. How does indirect exchange facilitate the strategy of “one step back.

.

However. Yet this was putting the cart before the horse. because without indirect exchange and especially the use of money.Lesson 8
The Division of Labor and Specialization
In this lesson you will learn:
• The definitions of division of labor (specialization) and productivity of labor. and a person called a “cobbler” who spent all day selling shoes (and shoe repair services) . One of its chief benefits is to foster the division of labor. trading options would be so limited that people would have to
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. • The advantages of the division of labor. which means that people specialize in different tasks in order to produce the goods in the first place .
The Division of Labor and Specialization
n the last lesson we learned that the use of indirect exchange—especially when the practice is taken to its logical conclusion with the use of money—greatly enhances the scope for beneficial trades . in the previous lesson we were taking it for granted that there was a person called a “butcher” who spent his time preparing and selling meats. a monetary economy doesn’t merely facilitate the rearrangement of alreadyexisting finished goods . • The principle of comparative advantage. to put it in other words.

Another way is through the division of labor. meaning that he could increase the number of coconuts he could acquire per hour of labor . which makes it practical for people to “divide the labor” that needs to be done and allow individuals to specialize in particular tasks . Why would modern civilization collapse without the division of labor? the quick answer is that the productivity of labor would plummet . even though some of them may have no need for the cobbler’s services . Very complex chains of production and trading can be arranged. Only through the use of money can very complex “favor swapping” occur. perform his own dental and medical procedures. Remember that Robinson Crusoe. Crusoe could greatly increase the productivity of his labor. where “the work” is
. was able to improve his lot—was able to achieve a life that he considered more pleasant—by using his labor to transform his environment . especially as the tools they used wore out. each person (or each household at the very least) would grow his own food. In effect. Rather than people specializing in various occupations and producing far more than they personally need. the use of money overcomes these limitations . make his own clothes. a dentist) who then does a “favor” for the butcher (by fixing his teeth) who in turn does a “favor” for the cobbler (by giving him some of his bacon) . alone on his desert island. We saw that through saving and investment (in order to create a pole out of branches and vines). As we have seen. imagine a world without it . In other words.114
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be largely self-sufficient . and the small band of survivors would live a primitive existence. Clearly in such a world. to grasp just how important the division of labor is. since at each step the sellers can unload their wares for money and then look for the lowest prices in their role as buyers . A shoe cobbler can buy goods and services from dozens of other professionals. But saving and investment is only one way to increase the productivity of labor . people instead try to be perfectly self-reliant . the use of money allows the cobbler to do a “favor” for a third party (say. and so on . and gasoline supplies ran out . machines broke down. then no individual could probably afford to become a shoe cobbler—he might get scurvy if no one with vegetables needed his shoes fixed for a few months . if a community of people only engaged in direct exchange. build his own furniture. most of the world’s current population would die within a month or two.

etc . even though the conclusion is sensible. scraped it into the garbage. and so forth under the division of labor . everyone can eat more. simply put. In our society. there is more total food produced. and some other people do all the dental work.
Why Specialization Makes Labor More Productive
Most people agree that if they had to grow their own food.. since there is more total stuff to go around. then stepped to the right to dry the same dish and finally put it away . the productivity of labor is magnified greatly when it is “divided” in this fashion . it’s useful to spell out some of the specific reasons that specialization makes labor so much more productive:
• Less time wasted switching between tasks. rather than everyone trying to produce a small portion of each item in the total pile of stuff . performing his own dental work. Most likely. with specialization some people grow all the food. and the third can dry . for the simple reason of cutting down on unnecessary walking . etc . For example. we have special names for these two groups of people: farmers and dentists . By having special individuals devote themselves exclusively to farming.
. make their own clothes. the kids can get the job done more quickly if they divide up the tasks and specialize. and individual workers specialize in one or a few tasks . one child can scrape the plates off into the garbage and carry the dishes to the sink . etc . and others exclusively to dentistry. then carried it over to the sink and washed it.. the same principle applies to other productive operations . and more cavities pulled. the second child can wash. people can produce more total stuff when they specialize in their tasks. this system is much more efficient—they will all be done much sooner—than if each child grabbed a dish. wear more clothes. making his own clothes. per year than would be possible without the division of labor . they would be plunged into abject poverty . Rather than each person growing his own food.Lesson 8: The Division of Labor and Specialization
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divided up into different types of tasks. Picture something as simple as three children cleaning up the table after dinner .

which is why people often ask. of course. and so on certainly doesn’t increase fifty times . its output will be higher if the workers specialize in their jobs within the factory because it’s then easier to incorporate machinery and tools to help them . • Economies of scale .
. the division of labor promotes the use of automation (machinery) .116
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• Promotes automation . rather than each roommate cooking a whole meal for him or herself every night . a strong boy in Idaho would probably be able to grow more potatoes per year than a sickly. if a chef switches from making enough pasta to feed one person to feeding fifty people. anyone else want some?” • Natural aptitude . some people are simply born to be better farmers than others—and this natural advantage can include geographical factors . there would still be advantages from specialization . “I’m making coffee. In the real world. people are not identical . And the bed-ridden boy in Idaho might be born with a wonderful knack for language. and thus makes a much better copy editor or novelist than either of the healthy boys who are much better equipped to be farmers . even if we just consider a particular factory. For example. it wouldn’t make sense for anyone to develop tractors . boiling the water. this is a generalization of the first two principles . so far our principles have shown that even if the whole world were filled with identical people. For many operations. By taking a complicated task and breaking it down into its components. there are economies of scale at least up to a certain level of output . Another everyday illustration of economies of scale involves making a cup of coffee: Whether you want to make one cup or four. but at the same time a strong boy in Florida can grow more oranges per year than even a strong boy in Idaho . bed-ridden boy in Idaho. this principle alone explains why it makes sense for roommates to alternate preparing meals. If everyone grew his own food in the backyard. the prep work is largely the same. For example. the time spent on preparation of the sauce. this principle means a doubling of inputs more than doubles the output .

if we followed that same person and checked in at age 50. But if the student with good math skills then went to college and majored in accounting. the true advantages of the division of labor occur when people develop their natural aptitudes through training and practice. Without the ability to move goods around the economy. the huge leap in “total output” (made possible by the division of labor) would be a hollow victory .
Enriching Everyone By Focusing on Comparative Advantage
It’s important to emphasize that the benefits of specialization can only be reaped when people are able to trade with each other . but it lays out some of the main reasons that labor is so much more productive through specialization . then obviously he would be far more proficient at the job—meaning his labor would be much much more productive—than any other human who did not have such a background . his superiority would be even more pronounced . someone who’s always had a “knack for numbers” in school would do a better job working at an accounting firm after graduating high school. while others focus on building houses. Finally. then it’s obvious that the two will both enjoy a higher
. Otherwise the farmers will freeze and the builders will starve . after he had spent twenty-eight years working as an accountant. It’s easy enough to see the mutual benefits of specialization and trade when two people have different areas of expertise . For example. whereas Bill is an expert at sewing pants. If some people focus on growing food.
the above list is not meant to be exhaustive. if Joe is really good at planting and harvesting wheat. practice .Lesson 8: The Division of Labor and Specialization
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• Acquired aptitude . practice. compared to another high school graduate who always struggled with math . then this arrangement only works if the farmers are allowed to trade their surplus food in exchange for some of the builders’ surplus houses .

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standard of living if Joe concentrates on producing wheat while Bill concentrates on producing pants . mopping the floors. As the numbers indicate. economists have discovered that the principle applies even in cases where one person is more productive in every possible way . he or she still benefits by specializing in his or her comparative advantage. However. since she is delegating the necessary tidying up to John . Marcia can allow customers to stay in the store and browse for longer (thus making more sales). Consider the table below:
Time It Takes to Perform Tasks in Clothing Store Tidy Up Store at Day’s End
John (hired help) Marcia (owner) 60 minutes 30 minutes
Convince Customer to Buy
120 minutes 15 minutes
In the table above. in preparation for opening the next morning . the principle of comparative advantage was traditionally used to illustrate the benefits of free trade in commodities between two nations. Because Marcia has the absolute advantage in both making sales and tidying up. etc . we can say that even if one person has an absolute advantage in every line of production. Marcia is better at both making sales and at tidying up the store at the day’s end. you might at first think that it is most efficient for her to spread her workday among the two tasks. but for our purposes we can make the point quite easily with an example of two people in a monetary economy . which is the field where the superiority is relatively greatest . Marcia can concentrate on her comparative advantage. rather than bringing John into the picture . By hiring John and having him focus on taking out the trash. we see the hypothetical performance times at a clothing store in the mall for John (hired help) and Marcia (the store’s owner) . In the jargon of economics. But that’s not correct . which is making sales .
. In other words. at the end of each day.

or a mere $10 per hour . As these hypothetical numbers illustrate. it is quite simple for her to figure out whether it makes sense to hire outside help (John) or whether she should close the store early so that she can tidy up herself . Marcia might sell $50 of clothes at the retail price. For example. Just to round out the discussion.Lesson 8: The Division of Labor and Specialization
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If Marcia is running her business in a monetary economy. both Marcia and John would consider the arrangement quite attractive . on average she thereby loses out on $40 in potential income from her business . If Marcia has to kick the customers out early. Because John is such a worse salesman than Marcia. John can make much more than that cleaning . or for John to quit the cleaning business and go into clothing retail .
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. it makes sense for Marcia to delegate these simple tasks to John .1 that means for every 15 minutes that Marcia devotes to helping customers on the floor. notice that it would not make sense for Marcia to hire John to help her with making sales. Does it make sense for Marcia to hire John. so long as he is willing to charge less than $40 to come in and clean up Marcia’s store at the end of each day. At any price in that range. he is happy to charge just $15 for his hour of work . there are large gains from trade between Marcia and John: It would be worth her while to pay someone up to $40 to tidy up her store. on average she brings in an extra $20 that she can pay herself . as well as the overhead expenses of renting the store space. Our example has illustrated the principle of comparative advantage: even though Marcia is more productive at both tidying up her store and in
For example. his net earnings would work out to an average of $20 every two hours. that means if John tried to replicate Marcia’s business and devoted himself to selling clothes. In a more advanced textbook you can learn the precise ways that businesses treat different expenses and calculate the earnings from a particular sale . suppose that the typical customer purchase yields Marcia net earnings of $20 . while John would be happy to do the job—which takes him an hour to complete—for anything more than $15 . paying the electric bill. since John is just a young guy with no significant skills. so that she can spend the last 30 minutes of each day tidying up. etc . he only makes a typical sale once every two hours (120 minutes) . but she in turn had to spend $30 (all things considered) for those clothes in terms of the original wholesale price. who runs a cleaning service catering to stores in the mall? It depends what John charges for his services .

) specialization and trade showers benefits on all participants. but he does have the comparative advantage in cleaning . she still benefits from associating with John . but only the comparative advantage in making sales .2 A rich and productive country like the united states still benefits from trading with a “backward” country where the workers are less productive in every line of work and production . (John has the absolute advantage in neither task. even when one of them is more technically capable than the others .120
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making sales. As we will see in Lesson 19.
the teacher’s Manual contains an exercise explicitly illustrating the application of comparative advantage to international trade in Lesson 19 . Marcia has the absolute advantage in both tasks. the principle of comparative advantage applies to international trade just as much as it does to Marcia and John .
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• The division of labor (specialization) greatly enhances the productivity of labor. Even in this case. and so forth. others concentrate on building houses. others concentrate on treating illness. • Even someone who is more productive in every activity can still benefit from trading with people who are not as productive. both parties should focus on the areas in which they have the relative superiority—the comparative advantage—and trade some of the resulting output. There is more total output when some people concentrate on growing food.Lesson 8: The Division of Labor and Specialization
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Lesson Recap •••
• One of the advantages of using money is that it allows people to specialize in different occupations.
.

Comparative advantage: Occurs when a person has the relative superiority in a particular task.)
. Absolute advantage: Occurs when a person can produce more units per hour in a particular task. there are economies of scale if doubling the amount of inputs leads to a tripling in output . For example.122
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new Terms
Division of labor / specialization: the situation where each person works on one or a few tasks. Economies of scale: A condition in which output will increase more than proportionally as inputs are increased . because Mary might have an absolute advantage that’s even greater in something else . (Jim can have a comparative advantage in a certain task. compared to someone else . and then trades to obtain the things produced by others . when taking all other tasks into account . Productivity of labor: the amount of output a worker can produce in a certain period of time . even if Mary has the absolute advantage.

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sTudy QuesTions
1. Why is trade important for the division of labor? 4.” 5. *Explain this statement: “The gains from trade in a case of absolute advantage are obvious. but they can be quite subtle in a case of comparative advantage. *If the world were filled with identical people. What’s the connection between specialization and the productivity of labor? 2. Why is Marcia the storekeeper willing to pay up to $40 to have someone clean her store at the end of the day?
. would specialization still be useful? 3.

.

It’s always possible that the business fails and the capitalist loses everything .Lesson 9
Entrepreneurship and Competition
In this lesson you will learn:
• The role of entrepreneurs in a market economy. the entrepreneur then gives
In the real world. Yet in reality. then the capitalist would earn a guaranteed return on his or her loan and would be selling “services” for an agreed-upon price just as the utility company sells electricity to the entrepreneur . electricity. and decides to start a new business or develop a new product . If a business loan were truly risk-free. the capitalist who lends to a new business always partakes in the entrepreneurial risk of the venture. regardless of the terms of the contract .
Entrepreneurship
T
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he entrepreneur is the driving force of a market economy . the entrepreneur uses savings (either personal or borrowed from capitalists1) to hire workers. and other inputs .
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. semi-finished goods. • How competition guides entrepreneurs. It is the entrepreneur who judges that something is missing in the market. rent land and equipment. and purchase raw materials. • Why workers tend to get paid the full value of what they contribute. the distinction between entrepreneurs and capitalists is blurry .

who simply loves baseball . When revenues are higher than expenses.2 On the other hand. and the would-be entrepreneur would actually be a consumer . especially if the man spent his own money to transform his (huge)
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. the customers of a particular business may be other entrepreneurs or the final consumer . a retired man might operate a Little League baseball field and charge the young children a modest fee to defray the expenses of hiring umpires and buying t-shirts. the entrepreneur earns a monetary profit . For example. landlords. But there is another entrepreneur whose business is the production of industrial-scale ovens. his opportunity cost of using his labor in such a manner is quite high . then the operation would probably be a hobby or a charity.3
We are referring to monetary profit and loss to avoid confusion with the broader concepts of subjective (or psychic) profit and loss. suppliers. where he uses a large oven. flour. but the whole effort could be recreational for the man. Although entrepreneurs may be motivated by factors other than monetary profits and losses. rather than an actual business. then he will probably abandon the business .126
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instructions to the hired help to use the tools. the entrepreneur could earn much more than $100 per month by closing his own business and working for someone else—namely. Expenses are the money that the entrepreneur must pay out to workers. If expenses are higher than revenues. For example. one entrepreneur might open a bakery. constantly suffering monetary losses with no apparent end in sight. if someone appeared to be running an operation year in and year out. machinery. and ends up with monetary profits of $100 per month. and others in order to continue producing his goods and services . and inputs to produce goods and services which in turn are sold to customers . and his customers are other entrepreneurs such as the baker and the owner of a restaurant .
Revenues are the money that customers pay to the entrepreneur for his products and services . if an entrepreneur spends 60 hours a week putting his heart and soul into a new business. which are ultimately what the entrepreneur cares about . water. the entrepreneur suffers a monetary loss . and a bunch of teenagers to produce crusty French bread for local families . For example. when people refer to a “successful business” they mean one that is profitable . the distinction between these roles can be blurry in the real world . even though he is taking in more dollars than he pays out. a more successful entrepreneur!
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Once again.

Competition ensures that entrepreneurs constantly strive to provide customers with goods and services at the quality they want for the lowest possible price . An insightful entrepreneur surveys the status quo and has a good idea to improve on the way that other entrepreneurs are currently serving their customers . no matter how rich a particular entrepreneur becomes. meaning that even the most successful entrepreneurs must continually earn their patronage day in. or changing the system of passenger seating for airline flights . competition is what regulates and motivates them .” —Ludwig von Mises. but arranges his affairs on the ground of his opinion about the future. or discovers a use for by-products that were previously
backyard into a baseball field. such as switching to a plastic (and unbreakable) ketchup bottle. the idea might be grand.
. day out . when an entrepreneur discovers a cheaper source of raw materials. Customers always have the option of taking their business elsewhere. Human Action. but he judges the future in a different way. such as the invention of a completely new product . Many innovations also occur on the production side. But often the innovation is quite modest. he can’t literally force a customer to buy his products .Lesson 9: Entrepreneurship and Competition
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The Contribution of the Entrepreneur
“What distinguishes the successful entrepreneur and promoter from other people is precisely the fact that he does not let himself be guided by what was and is. the competitive process unfolds through a process of imitation and innovation .
Competition Protects Customers
If entrepreneurs are the driving force in a market economy. He sees the past and the present as other people do. p. In a pure market economy. every transaction is voluntary . 582. it would be clear that the operation wasn’t really a for-profit business and that the man wasn’t looking for a certain monetary return on his investment .

the story does not stop there . most entrepreneurs are motivated by the desire to earn monetary profits . monetary profit (and hence “markups”) will be whittled away. versus the money he himself had to pay to produce the item . even those firms that are “on top” in their respective industries are constantly researching new ways to stay ahead of the competition . One of the most beautiful aspects of a market economy is that it harnesses some of the most selfish. but their customers . In practice. ambitious. even tiny reductions in expenses can translate into huge differences in profits . If a particular entrepreneur is charging his customers a large markup relative to his expenses. When a particular entrepreneur comes up with a successful innovation. as he has done . and talented people in society. he earns relatively high profits . When magnified in large-scale operations. in a free market he can’t prevent
.
Competition Protects Workers
In the previous section we saw that competition protects consumers from arbitrarily high prices . the ultimate beneficiaries of the competitive process are not the entrepreneurs. but competition among entrepreneurs keeps them honest . the only way to earn profits is to serve customers (while keeping expenses down) . Over time. and makes it in their direct financial interest to worry at night about pleasing others .128
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thrown out . the success is temporary . or improve the quality of the product. the business world never sleeps . When a particular entrepreneur makes a successful innovation and earns extraordinary profits. Yet in a market economy. But so long as there is competition. Many critics of the market economy are horrified at the huge “markups” that sometimes occur. entrepreneurs drive the market economy. there is a tendency for businesses to produce goods and services of rising quality and falling prices . as competitors try to gain market share by offering a similar product at a slightly lower price . Other entrepreneurs see his success. his competitors discover how to lower their expenses. Only by constantly introducing further innovations can a particular entrepreneur enjoy a steady stream of monetary profits . and they begin to imitate it—while looking for further ways to make slight modifications and introduce yet more innovations . Over time. meaning that there is a large gap between the price an entrepreneur charges for a product.

4
Again. we need to understand the employee’s actual contribution . because of the additional output . It is true that a particular worker—especially with a family to feed—may not have much “bargaining power” and will have to accept a very low wage if that’s the only offer available . Yet in a pure market economy.4 On the other side of the business. then the employer uses this information to calculate how much extra revenue his operation will bring in. this means that the employer should look at his total business output. competition ensures that employers do not “underpay” for the labor services—and other resources—that they must hire or purchase in their operations . In order to judge whether an employee is getting paid a “fair” wage. Customers are charged a “fair” price for products and services. some employees are more productive (and hence valuable) than others. even if an entrepreneur sells a product for a price much higher than the amount of money he spent in procuring the item.5 After all. some of the brightest minds in society had not yet come up with a way to deliver those items at lower prices—even though they would have reaped financial rewards from doing so . competition ensures that customers do not “overpay” for the goods and services they desire . the customer still values the product more than the money he spends on it—both the customer and the entrepreneur subjectively benefit from the trade . in the sense that at the moment of sale. In the long run. How then does an employer decide what he’s willing to pay a potential new hire? economists say that the employer should try to calculate the marginal productivity of the potential new worker .Lesson 9: Entrepreneurship and Competition
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a competitor from offering the same product at a slightly lower price to win over his customers . competition protects workers from arbitrarily low wages . In the long run. every transaction is voluntary and fair in a very important sense . a tight-fisted employer can’t prevent a competitor from coming along and offering a slightly higher wage to win over the underpaid employees and drive the tight-fisted entrepreneur out of business .
5
. we have put “fair” in quotation marks because every labor contract is fair in the free market. in the sense that it is voluntary and the worker subjectively values the wages more than the leisure he or she gives up by accepting the job . these
We have put “fair” in quotation marks because in a pure market economy. with and without the new worker . so it makes sense that different employees will be paid different wages .

6 Competition
things are not as simple as we made them sound in the text above . Bob.) If the typical table of patrons pays $26 to Rita for a meal that costs her $20 to prepare—not counting the paycheck she gives to Bob—then Rita would be willing to pay Bob up to $12 per hour . For example. an upper limit of how much the employer would be willing to pay for the new worker . Of course. “How much would sales fall if Paul McCartney didn’t play?” because then McCartney and Lennon would each seem to deserve
6
. just as it prevents him from “overcharging” his customers for very long . meaning the hostess has to ask incoming customers to wait a few minutes before being seated . the only logical stopping point would occur when Bob was being paid according to how much extra money his services brought in to the employer . But if she offered him only $4. on average. say. Rita finds a candidate. there are several tables in the restaurant that are dirty. ultimately. and who seems to be very courteous and responsible . But competition ensures that he can’t get away with “underpaying” employees for very long. and each group of diners takes an average of 30 minutes to order their food. in practice the employer will try to pay less than the marginal productivity of a potential new worker—just as in practice he will try to charge his customers a large markup . suppose Rita owns a restaurant that is very busy . after a week of getting used to the new job his presence will allow her restaurant. to serve an extra 2 tables per hour . In some cases there are several factors that are indispensable for the final output. eat the meal. and leave . Rita estimates that if she offers Bob the busboy position. $5 per hour . then Bob would surely be able to sell his services to a competitor restaurant for. who has had previous experience as a busboy at a busy restaurant.130
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calculations provide a ceiling. now there are only 3. so it is difficult to isolate the “marginal productivity” of any one factor . Rita would hope to hire Bob for less than $12 per hour . Rita notices that a major bottleneck in her operation is the cleaning of a table after the customers leave . Rita realizes that it makes sense for her to hire an additional busboy to help the current busboy clean tables and get them ready for new customers . At any given time. (Perhaps instead of there being 4 dirty tables at any time. Of course. (How do the Beatles split up the proceeds from their concert performances and record contracts? It wouldn’t really work to ask.

Finally there is the complication that workers won’t have the same marginal productivity in different businesses .Lesson 9: Entrepreneurship and Competition
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among entrepreneurs provides a tendency for workers to be paid for their contributions .
more than half of the proceeds . if Bob the busboy would add $12 to Rita’s operation. meaning that competition will have to change their wages too if they had previously been paid a “fair” amount .) Another complication is that the addition of more workers can change the marginal productivity of the original workers. For example. You will need to consult a more advanced book on economics to learn the solution to these complications .
. then competition really only ensures that Bob gets paid at least $10 . but only $10 to the next restaurant that needs a busboy.

then another employer—who only wants to make more money himself—can offer higher pay and entice the worker away. They hire workers and buy resources. If they underpay. • Competition also pushes entrepreneurs to pay workers the full value of their contribution to the business. in order to produce goods and services for sale to the consumers. and to charge the lowest possible price for the level of quality that the customers desire.
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Lesson Recap •••
• Entrepreneurs are the driving force in a market economy. • Competition pushes entrepreneurs to produce goods and services that their customers value.

Expenses: The amount of money an entrepreneur spends on labor. Marginal productivity: the increased revenues that result from hiring an extra worker . Competition: the rivalry that exists between entrepreneurs who have the option of hiring the same workers and buying the same resources.
. Monetary loss: the amount by which expenses are greater than revenues . Monetary profit: the amount by which revenues are greater than expenses . Revenues: the amount of money customers spend on an entrepreneur’s output during a period of time . and other inputs during a period of time . in order to produce goods and services to be sold to the same customers . raw materials.Lesson 9: Entrepreneurship and Competition
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new Terms
Entrepreneur: the person in a market economy who hires workers and buys resources in order to produce goods and services .

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sTudy QuesTions
1. What motivates and regulates entrepreneurs in a market economy? 4. why are all capitalists also entrepreneurs? 3. *In the real world. Why is the entrepreneur the “driving force” of a market economy? 2. How does competition protect workers?
. How does the competitive process unfold through “imitation and innovation”? 5.

saving. the concepts are similar but easier to define . income (or earnings) is defined as revenues minus expenses .Lesson 10
Income. and investment in a monetary economy.
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. and investment . • How saving and investment increase an individual’s future income. due to the sale of labor services and the earnings of assets that the individual owns . and Investment
In this lesson you will learn:
• The definitions of income. We recall from the previous lesson that revenues are the total amount of money customers spend on the business’
I
n Lesson 4.
Income. • How saving and investment increase an economy’s future output. For a business firm. Saving. For an individual. we saw that even Robinson Crusoe. could classify his actions with the concepts of income. income typically refers to how much money he or she can spend on consumption during a certain period of time. and Investment
In a modern economy with many individuals who use money. stranded on his island and with no one to trade with (except nature). Saving. savings.

the difference becomes savings . Prodigal Paul and Frugal Freddy .” this hair-splitting debate is relevant when economists argue over whether an economy can get stuck in a situation where savings is higher than investment . the tables on the following page illustrate the pros and cons of investment by looking at two hypothetical people. In our example. and invests $15. spends $80. and invested $15.000 in stocks and the other $5. they would say that the person had $20. because it would quickly lead to many accounting technicalities that are beyond the scope of this discussion . However.000 sitting in the bank account is part of savings but not part of investment . We do not discuss this in the text.2. For example.1 When an individual spends less on consumption than his or her income during a certain period. some economists would say that investment can be lower than savings.3
Investment Increases Future Income
the downside of saving (and investment) is that it reduces how much consumption you can enjoy today .136
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products and services .000 of total savings. it is called investment . however . investment can’t be higher than savings .000 in income. On the other hand. expenses are the total amount of money the business spends in producing those goods and services . In the real world.000 on consumption.) When the individual spends some of his or her savings in order to generate more future income.
2
In any period of time. then some economists would say the remaining $5.000 in “cash .and after-tax calculations . if someone earns $100.
note that because we are still in the section of the book describing a pure market economy. (If saving is negative—meaning the individual consumes more than his or her income— then it is called borrowing or dissaving .000 in stocks. other economists would argue that investment is necessarily always equal to saving . the benefit of saving (and investment) is that it increases how much you can consume in the future .
3
. we are not discussing taxes . however.
1
Business firms too can invest in order to boost future earnings . various definitions of income account for pre.

But as the table illustrates. Paul enjoys more consumption than Freddy . even though Frugal Freddy always consumes a much lower proportion of his income. and their paychecks drop to $0 . even someone making $50. One last interesting observation is that in the 48th year of his career. In the earlier years. but for now you just need to know that in any given year. and plows it into his financial assets . However. the tables illustrate the different lifestyles caused by these savings decisions . flashy jewelry.783 is greater than Paul’s consumption of $50. both men save some of their income and invest it in assets that pay 5% interest per year . except for the proportion of their incomes that they save . and spends the rest on consumption—going out to dinner. and so forth . He is able to attend more parties. Freddy can spend more on immediate enjoyments than Paul can afford . and generally have more fun . because he has been so frugal in his early working years . wear nicer clothes. by the 26th year. and who invests in moderately safe assets. in addition to their paychecks Paul and Freddy earn interest income equal to 5% of the total market value of their investments .560 . (We assume this
.000 per year. the two men have identical incomes from their labor services every year— they both earn the same paychecks from their jobs . In fact. as the years pass. Many people think that only “rich people” can ever get their hands on a million dollars . sets aside 30% of his total income each year. vacations to tahiti. on the other hand. But Freddy’s middleaged years are much more prosperous. Paul and Freddy are identical. From that point forward. his income itself is growing much faster than Prodigal Paul’s . Freddy’s consumption of $50. can eventually accumulate $1 million simply by habitually saving a large fraction of his income—at least in a world without taxes!
Retirement
On the following set of tables we look at what happens after Paul and Freddy stop working. they hold comparable jobs and earn a steady paycheck of $50. the gap between the two men constantly shrinks .000 each year from selling their labor services .138
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the tables track the financial activity of Paul and Freddy throughout their lives . Freddy’s financial assets break the $1 million mark . Remember. Frugal Freddy. Prodigal Paul only saves 5% of his income each year. We will discuss debt and interest payments in more detail in Lesson 12. However.

000 left in his estate to bequeath to his heirs . not only can the men spend money that is generated by the interest earnings on these assets.1 million . He drops down to $15. (We are still describing a pure market economy. thus Freddy not only has a much larger annual income from investment earnings during retirement.) Both men now begin dissaving. but it is still a quite comfortable lifestyle—and it’s 40% more than his whole paycheck was during his working years! In contrast.
In the tables. After living on an austerity budget of $5. because he has exhausted all of his financial assets . churches. but he even has almost $592. At this point.000 per year . (this is called reducing the principal of one’s assets or savings . not only has Freddy’s frugality allowed him to fund his own retirement without relying on the generosity of others. As the tables show. he can’t even eke out his $15.140
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happens in the 52nd year after they have entered the work force . note that parentheses are an accounting convention to denote negative numbers . so there are no government relief programs . the reason Paul is in such dire straits is that at the time of retirement.) Again in sharp contrast. but they can also sell off a portion of the assets and consume the proceeds of the sale .4 this is possible because they have accumulated a stockpile of financial assets . this is a tad lower than what he was used to just before he retired.384 this year. During his retirement years. If he doesn’t want to go back to work. he can easily afford to maintain a constant level of consumption of $70. meaning that they consume more than their incomes each year . Paul is flat broke . he had only accumulated about $136. but he also has a much larger stockpile of assets to “draw down” and fund his retirement lifestyle .) At this point we really see the benefits of Freddy’s relative frugality . the real crunch for Paul comes in Year 64 . he will need to get money for consumption from relatives.000 in annual consumption .000 in assets.
4
. whereas Frugal Freddy had over $1 . Frugal Freddy can continue his very comfortable retirement lifestyle up until the 75th year after he began working. or some other philanthropic organization .000 consumption for the year. when we assume he passes away . Prodigal Paul has to sharply cut back on his consumption spending once he stops going to work .

Perhaps this made her rearrange her planned spending that day. you should not conclude that all savings and investments are of this nature . what basically happened is that Bill financed his consumption with an “advance” made by sally . In a sense Bill’s total monthly consumption was lower. On the Monday in question. when Bill left his wallet at home. if sally’s normal paycheck were also $5. many people—if pressed—would explain this increase to the saver’s income by an offsetting reduction in the income of a borrower somewhere in the economy . then he would actually only have $4.999 to work with. Given his mistake. sally provided a definite service to Bill . both parties benefited from the voluntary loan transaction . but he preferred having $1 less in order to obtain his usual $10 lunch on the particular Monday . there is nothing irrational or “uneconomical” about Bill’s decision to pay $1 for sally’s loan . it constitutes a large portion of the credit card industry . In any event. in reality both parties benefited . Saving. At the same time.001 to work with. Making loans so that borrowers can finance their present consumption (at the expense of future consumption) is certainly part of what happens in a market economy on a grand scheme. For example. However. then this particular month she would actually have $5. In other words. if Bill (the borrower) forgets his lunch money on Monday. even though it might seem from a quick look as if Bill lost and sally gained. or perhaps it simply meant that sally carried less cash in her own purse than she originally had desired .000. he might ask his coworker sally (the saver). sally had to have in her pocket enough spare cash to lend $10 to Bill . because of his $1 expenditure in “buying a loan” from sally . In the scenario above. if Bill’s take-home pay that month were $5. “Can you lend me $10 and I’ll pay you back $11 tomorrow?” If sally agrees. and Investment
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How Saving and Investment Increase An Economy’s Future Output
everyone who has held a job and a bank account understands the potential benefit of postponing consumption today in order to enjoy greater consumption in the future . after earning $1 in providing “lending services” to Bill .Lesson 10: Income. However.000. this is certainly a possibility . When we consider the lifetime savings
. then it’s clear that her $1 in interest on the personal loan was paid out of Bill’s reduced income for that month .

and designer clothes . How is this possible? For every sally who saves and earns ever-growing streams of interest income. the laid-off workers would look for jobs in other industries. each person would cut back on consumption . either directly (through buying corporate stock or bonds) or indirectly (by depositing the money with banks which then advanced loans to businesses) . and this extra competition would push down wage rates in those sectors . and they would lay off workers and cut back on their inventory . these large swings in how people spent their incomes—diverting it away from consumption and toward investments—would ultimately steer workers and other resources out of industries catering to immediate consumption. there doesn’t need to be one or more borrowers who grow ever deeper in debt as the decades roll on . electronic gadgets. but for now we just need to understand the big picture of what would happen if everyone in society suddenly decided to save a large fraction of his or her income . For example. the key is that the loans or investments can be made in productive enterprises. people would increase the amount of money they lent and invested in businesses. At the lower wage rates. Other resources besides laid-off workers would be redirected to new uses. high-end retail and jewelry stores would see their sales plummet. the owners of now-vacant buildings (which used to house clothing stores and other retailers) would
. rather than simply being lent to an individual who increases his consumption in the present . sports cars. in principle allowing every member of society to enjoy larger incomes . In order to save more.142
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plan outlined in the previous section. In fact. as well . If the savings are channeled into expanding production (rather than merely financing consumption). businesses in these other industries would be willing to hire the displaced workers . At the same time. Fancy restaurants too would lay off workers and close down some of their locations . doesn’t there have to be a Bill somewhere who borrows and pays ever-growing streams of income? Yes and no . it is possible that every single person in a market economy provides for a comfortable retirement through saving and investment during his or her working career . that means people would spend less on fancy restaurants. and toward industries catering to long-range production . For example. In Lesson 12 we will go over the mechanics of credit and debt more carefully. then “total output” grows over time.

. and Investment
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lower their asking price for rents.Lesson 10: Income. It is not true that a lender grows rich only when a borrower grows poor . this is a very complex area . there is no “cheating” going on here. If we ignore the real-world disruptions that would occur during the transition. everyone’s income can grow larger over the years when everyone is more physically productive because of the growing stockpile of capital goods . In the present lesson. Saving. the essential insight is that a sudden increase in savings allows the economy’s output to shift away from consumption goods and into capital goods . the accumulation of capital goods directly raises workers’ incomes through higher wages (because each hour of work—with the better tools—now produces more output) . because the laid-off waiters and mall employees would now be working in factories producing drill presses and backhoe loaders . even a large and sudden increase in the savings rate wouldn’t affect “total spending . Just as Robinson Crusoe was able to enhance the power of his bare hands through the wise use of saving and investment—even though he had nobody to “lend to” on the island—so too can the whole population enhance each other’s labor productivity by channeling more resources into the production of machinery and tools .” It’s true that consumption spending would (initially) be much lower. In Lesson 12 we will give a longer explanation of how interest rates are determined . we are only making the important point that it’s possible for everyone to grow richer through saving . For example. making it easier for other businesses to expand their operations by filling the buildings . but investment spending by businesses would be correspondingly higher . the total number of jobs (eventually) would also be the same.

It is possible for every single person in the economy to save large sums and enjoy a much higher future income. an individual can save and invest today. but the new tools make workers more productive in the future. • When individuals save and invest. the economy is physically transformed. in order to increase his or her income in the future. production is redirected toward making tools and equipment. • One person’s saving and investment doesn’t force someone else to sink ever deeper into debt.144
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Lesson Recap •••
• Because of interest. This reduces the amount of consumer goods produced in the present.
. A small decrease in consumption today. can lead to a much greater amount of consumption in the future. Instead of channeling labor and other resources into making television sets and DVDs.

Lesson 10: Income.000 today and is paid back $1. from the sale of labor and the earnings of other assets (such as stocks) .000. Saving. Income / earnings (business): Revenues minus expenses . For example. Interest is usually quoted as a percentage of the principal (the amount of money originally lent) earned per year .
. Savings: the amount by which income is greater than spending on consumption . if someone lends $1. Interest: the income earned during a period of time from lending savings to others .050 twelve months later. Investment: savings that are spent in the hopes of increasing future income . then the principal is $1. and Investment
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new Terms
Income (individual): the amount of money that can be spent on consumption goods in a certain period. Borrowing / dissaving: the amount by which consumption spending is greater than income . the interest earned is $50. and the interest rate is 5% .

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sTudy QuesTions
1. Can investment occur without saving? 2. What are the pros and cons of saving a high fraction of your income? 3. If someone borrows in order to buy today rather than waiting to pay cash. is this an example of uneconomical behavior? 5. *Is it possible for every individual in the community to accumulate assets for retirement—or does one person’s rising wealth translate into someone else’s rising debt?
. What’s the connection between saving and retirement? 4.

just as the specific numbers used in some of our stories in previous lessons were not crucial to the general economic principles that we were illustrating . you should never ascribe too much importance to the particular supply and demand curves we will draw in this (and subsequent) lessons . they are simply convenient ways to give a concrete example of a particular point. However. • The law of supply and the law of demand.L e s s o n 11
Supply and Demand
In this lesson you will learn:
• The definitions of supply and demand. “supply and demand. the parrot would also need to be trained to disagree with half of the other parrots . this is almost right—to be truly a good economist.
Supply and Demand: The Purpose
A
n old joke says that if you taught a parrot to say. Its pages are not covered with the graphs you will find in a typical economics textbook .” it could answer any economics question . the one exception to this rule is the famous supply and demand graph . • How economists use supply and demand to explain market prices. In addition to the concepts underlying the graph.
the lessons contained in this book are designed to give you a solid foundation in economic thinking .
147
. we provide diagrams because it makes some of the points easier to grasp .

because superior tools have yet to be discovered . and she plans on stopping at a station on her way home from work . At a price of $4 or higher per gallon. and the total number of units that consumers want to purchase at each hypothetical price . It is important to remember that someone’s demand for a good or service can change from moment to moment. they rather use them as tools . the concepts of supply and demand are ways of viewing the world . virtually all practicing economists use supply and demand to explain market prices. depending on the person’s subjective preferences as well as other factors . because that would strike her as an unusually high price and she would hope to fill up at a different station the following day . the situation we had in mind for the numbers that follow is that Jennifer’s car is almost out of gas.
Demand: Its Definition and Its Law
Demand is the relationship between various hypothetical market prices for a good or service. we have further assumed that Jennifer only has $16 in her purse. they allow economists to group different forces or causes into two different categories. on a particular tuesday afternoon . We have stressed that this is a snapshot in time. there will never be evidence that demonstrates that “supply and demand” is somehow false . For now. the following table illustrates Jennifer’s demand schedule for gasoline . economists often use the term demand schedule .
the demand schedule that follows lists the amount of gasoline that Jennifer would buy at various hypothetical prices .148
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Keep in mind that economists don’t rely on a theory of supply and demand. What might happen is that future economists decide that “supply and demand” is no longer the most useful approach to thinking about prices . not an empirical theory. and that her car has a 15-gallon tank (which is
. to remind us that demand is not a specific number. but rather a relationship among many numbers. Jennifer would not buy any gasoline. in order to think clearly and systematically about changes in the world and how they will impact market prices . A demand schedule can be constructed for one person or for many people . namely. to motivate the other numbers. Because supply and demand are conceptual tools.

or buying fewer units of a designer handbag if its price were too low and hence it ceased to be a status symbol . Finally.00 and $1 . which states that holding other influences constant.0 0 . at $1 .00 $0 .50 and $3 . At the prices of $3 . will necessarily buy at least the same number of units as a good’s price falls .0 8 .00 per gallon. the only “rule” that the schedule above obeys is the Law of Demand.00 $4 .50 $3 .0 10 .Lesson 1 Supply and Demand 1:
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Jennifer’s Demand for Gasoline on Tuesday Afternoon Price (dollars / gallon)
$5 .7 14 .00 $2 . enough to get her back and forth to work the next day (though she gives herself a bigger cushion at the lower price) .1
some economists view the “law” of demand as an empirical tendency. “Gravity tends to make things fall . As a consumer buys more units of a good.7
almost empty) . similar to a physicist who observes.5 4 .7 14 . Jennifer would only buy a small amount of gas.50 $1 . while at $2 . it is not an empirical tendency. Other economists interpret the Law of Demand as just that—a law .50 she would buy more gasoline because of the better deal. At $2 .50
Quantity (gallons)
0 .00 and $0 . and so it is only natural that a consumer who spends his or her money in order to satisfy the most important goals. For them.5 2 . there are occasional exceptions to the law of demand.00 $3 . a lower price will lead a consumer to buy either the same or a greater amount of the good or service .50 $2 . referring to physical objects and sales figures . each successive unit is less important.0 1 . she would fill up her car completely .00 $1 .50.” In this view. Rather.50 she would spend all of her cash . because we can imagine someone buying fewer silver bars if their price were very low. they prove the Law of Demand is true by thinking through the logic of economizing action . the apparent counterexamples
1
.

00 $7 .00 $5 .Lesson 1 Supply and Demand 1:
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Again. Jill doesn’t own a car.0
20 . because “the market” is simply the combination of the individuals . it is also true for the market demand for gasoline.0
10 . the only explanatory comments for the numbers in the table are that Hank is on a road trip for his company. it’s a simple matter of plotting points to graph the market’s demand curve:
Market Demand for Gasoline
$8 .00 $3 .00 $6 .00 $1 .0
30 .00 $4 .0
40 . Once we have the market demand schedule. so he fills up his tank regardless of the price . and his travel expenses will be reimbursed.00
$-
w w w w w
w w w
w w
w
w
50 .0
. the only specific rule that the above table obeys is the Law of Demand . since it is true in each individual’s case. so she buys no gasoline regardless of the price .0
0 .00 $2 .0
w w w
60 .

00 $2 . Our hypothetical numbers obey the Law of Supply.50 and $3 .0
w
w
w
w
w
w
w
w w w
50 .00 $5 .00 $6 . and at a high enough price he leaves his farm work to set up a roadside stand and sell some of the gasoline back to other motorists . Here is what a generic supply curve looks like:
.0
150 . If the price should fall too low. Farmer Jim finds it worthwhile to enter the market .00
$-
w w w w w
0 . the Quik Mart and Fill ’er up . At a price of $6 . they use various techniques to sell larger quantities—such as working through their lunch breaks. and rushing outside whenever a customer pulls up in order to pump the gas at no additional charge (and thus clear out the pump for the next potential customer) .00 per gallon .00 $3 . the other of 200 gallons—assuming a market price between $2 .0
200 .0
300 .0
the story behind the above figures is that there are two single-pump gasoline stations in town. keeping the store open longer. producers offer the same or greater number of units . He has backup gasoline on hand to run his equipment.00 $1 .154
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Market Supply of Gasoline
$8 .0
250 . the owners arrange for the periodic replenishing of their underground fuel tanks—one of which has a capacity of 50 gallons.00 per gallon or higher. they simply shut their stores and hope they can fetch a better deal in the near future .00 $7 .00 $4 . which states that as the market price of a good or service rises. As the price rises.0
100 .

When something changes—such as consumer tastes.Lesson 1 Supply and Demand 1:
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Generic Supply Curve
P s
Q or
P
s
Q
Using Supply and Demand to Explain the Market Price
the whole purpose of using the concepts of supply and demand is to organize our thinking around different changes and how they will affect market prices . or
.

the definition of supply (at various prices) is how many units producers would sell if they actually received that hypothetical price for every supplied unit . In this context.2 On the other hand. If the market is in equilibrium. there is no surplus and no shortage . the same principles apply.5 gallons that they had planned on selling but couldn’t . even from minute to minute if need be . market forces would push it down . a ball at rest on a table is in equilibrium because the downward force of gravity is exactly counterbalanced by the upward force of the table pushing against the ball .” A gasoline station can actually change prices very quickly. market forces would tend to push it up . In our example. Consequently the owners would raise the posted price.50. (In physics. but to be realistic the story would involve a home buyer lowering his or her asking price after (say) several months of finding no buyers .50 per gallon. if producers thought the market price on this tuesday afternoon would be $3 . If the owners of the Quik Mart and Fill ’er up stubbornly clung to the price of $3 . such as housing. specifically.50. they would end up with a surplus of 108 . different markets have different degrees of price “stickiness . Other markets.) the idea is that if the price for some reason happened to be more than $2 .50 per gallon of gasoline .5 gallons during the course of the day .
2
. the equilibrium price (or the market-clearing price) is the one at which the amount supplied exactly equals the amount demanded . if the market price should happen to be below $2 . Because the owners of our gas stations would soon realize that they had misjudged the market—meaning that they would not be able to sell a combined 130 gallons for $3 .50 on this tuesday afternoon. they would plan on selling a total of 130 gallons of gasoline .Lesson 1 Supply and Demand 1:
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producers want to sell (at a particular price) .50 each—they would reduce the posted gasoline price and revise their ambitious sales projections . so that they could
Of course in the real world. But at this posted price. this price is in equilibrium because it balances the pressures of the consumers and the producers . usually see much slower price changes . For example. the owners would realize that customers were buying gasoline in larger quantities than the owners had planned on selling at the low price . the equilibrium market price is $2 . consumers would only start buying at a pace to purchase a total of 21 .

50 per gallon . the equilibrium price and quantity line up with the intersection of the curves.158
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earn more profits and avoid the awkward situation of having to shut down the store early and send customers away with no gas . as we show below . we would expect that in practice the actual market price would be $2 . In a generic supply and demand graph. this is the equilibrium quantity . In many textbooks. especially if we assume that the supply and demand schedules remained fairly stable in our hypothetical community. the sizes of the surplus and shortage are also indicated by the respective brackets . At this price.
. Our intuitive arguments show that the only “stable” or equilibrium price for gasoline is $2 . these items are denoted P* and Q* .
P s P* D
Q*
Q
We can also use the generic graph to denote a surplus (from a price PH that is too high) and a shortage (from a price PL that is too low) .50 (or very close to it) . producers want to sell exactly as many gallons as consumers want to buy—36 gallons with our specific numbers .

which will raise prices . Our fifth example will involve simultaneous changes to supply and demand . at the higher prices there will be less demand for oil. and then we’ll deal with two examples of changes on the demand side . We’ll first deal with two examples of changes on the supply side.Lesson 1 Supply and Demand 1:
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P
suRPLus
PH P* P
L
s
sHORtAGe
D Q
Q*
Using Supply and Demand to Understand Price Changes
People who are untrained in economic thinking often tie themselves in knots when they try to analyze some world event and its impact on prices . which will lower prices . many people—sometimes even newspaper reporters!—will say nonsense like this:
“the OPeC announcement means a reduction in the supply of oil. if OPeC countries announce that they are reducing their output of oil.”
thus we apparently conclude that the OPeC announcement will both raise and lower oil prices! now that you are armed with the tools of supply and demand analysis. For example. However. you can avoid such silliness .
.

(this will be our strategy for all of the examples in the remainder of this lesson . or both? the OPeC ministers are clearly reducing the supply of oil . now we have changed our minds.) We’ll first draw two arbitrary curves and come up with P* and Q* for the situation just before the OPeC announcement:
P s
P*
D Q*
Oil Market
Q
now we want to examine the impact of the OPeC announcement . What effect will this have on the oil market? If all we want to figure out is the direction of the (equilibrium) price and quantity change. let’s deal with the oil example we just discussed . suppose that the OPeC countries announce that they are cutting their production of oil by several hundred thousand barrels per day . we can use generic supply and demand curves . we will sell fewer barrels than we
. Does their decision affect the supply curve. the demand curve. depending on the price of oil .160
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Example 1: Supply Reduction
For this first example. We can translate their statement like this: “Before we had various quantities of barrels of oil that we would sell. and for each hypothetical price.

) As we’ll see.” remember that it is the entire relationship between hypothetical prices and quantities—demand is not simply one number . the reason for the latter phrase is simple enough: Graphically. but that by itself doesn’t mean that demand has shifted . we’ll keep the demand curve the same ... the leftward shift in supply leads to a higher (equilibrium) price of oil and a lower (equilibrium) quantity of oil produced and purchased . When you think of “demand. Clearly the OPeC announcement is much more about a supply shift than a demand shift .
3
.
In reality. no. while we merely moved along the same demand curve .Lesson 1 Supply and Demand 1:
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would have yesterday . the vast majority of buyers of oil don’t directly care about how many barrels OPeC is producing . Another way of making this crucial distinction is to say that we moved the supply curve itself. (think of the demand schedule—i . their demand schedule—the OPeC announcement probably won’t have much of an effect . we could come up with complicated stories of why some oil purchasers—particularly speculators who might stockpile oil based on their estimates of future prices—might have their individual demand schedules change because of the OPeC announcement itself . with a movement along the demand curve .e . Really what’s happening is that we’re drawing a new curve altogether. As the following chart indicates. this is a subtle mechanism and lies outside the scope of our basic discussion in the text . we should ask: Will the OPeC announcement affect the demand for oil? Here we need to be careful . to be precise.” Before drawing our new graph. However.3 so in our graph below. the whole table—to keep this straight . but visually the new curve looks like the old curve “shifted to the left . economists would say that the demand for oil remained constant.” economists refer to this as a reduction in supply or a leftward shift in the supply curve. but the quantity demanded declined . But as far as their willingness to buy more or fewer barrels at various hypothetical prices—i . Our hypothetical journalist above—who ended up concluding that the OPeC announcement would lead to both higher and lower oil prices—got confused on this essential point. the OPeC announcement will definitely affect the equilibrium quantity of oil purchased.e . a reduction in supply appears as a leftward movement in the supply curve . he mixed up a shift in demand. this information is only relevant to them because they know (from basic economics) that the OPeC decision will affect the price of oil .

and holding everything else constant. after they have come up with a list of all the different factors that could influence producers’ decisions on how much to sell. economists can map out the demand for the good . this list of causes could be huge. the supply schedule (and curve) is then the tracing out of the thought experiment where only the price of the good is allowed to change. the economists hold every single one of those influences constant. while all the other influences are held constant . the demand schedule (and curve) traces out the thought experiment where economists hold constant all factors that could possibly affect consumers’ desires to purchase quantities of a good. economists are not saying that the price of a good is the only thing that affects the quantity that producers want to sell . what we’re doing is trying to figure out which list the factor belongs in .162
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P P2 P1
s2 s1
D Q2 Q1 Q
Oil Market We already see the tremendous benefit of carefully defining supply and demand . similarly. When we’re trying to analyze the impact of some change. then. except they allow the price of the good to change . But when economists construct a supply schedule or draw a supply curve. By varying that one element. What economists have basically done is first take everything that could possibly affect producers’ decisions to sell various quantities of a good . and even the possibility of civil war . then. so to repeat. including the weather. they are holding all the other influences constant in order to isolate the effects of the change in price . Is it
. the producers’ forecasts of future customer behavior. except the price of the good .

they will probably be willing to sell more oranges at various hypothetical prices than they would have in the case of normal weather . What effect will this have on the price of oranges? the unusually good weather means that farmers will have more oranges than they normally have after their harvest . As the graph shows. a rightward shift in supply. At the same time. we can say that the unusual weather won’t influence the demand for oranges . In other words. For all practical purposes. meaning the supply curve shifts to the right . the weather per se probably doesn’t have a very big effect on consumers’ willingness to buy oranges at various prices . Consequently. leads to a lower (equilibrium) price and a higher (equilibrium) quantity:
P s1 s2
P1 P2 D Q1 Q2
Q
Orange Market
. supply has increased.
Example 2: Supply Increase
suppose the weather is very accommodating and the orange crop is unusually large .Lesson 1 Supply and Demand 1:
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something that will influence producers and how much they would be willing to sell the good in question? Is it a factor that will influence how much consumers would be willing to purchase of the good in question? Or both? Let’s move on to another example . coupled with a stable demand.

a fall in the price of jelly will increase the demand for peanut butter . if any. so the connection between price and demand for complements is the opposite of the connection in the case of substitutes .4 When the price of a good goes down. the desire for fruit) . which increases the supply of oranges and doesn’t affect the demand for oranges . will this have on the market price of apples. apples and oranges are substitutes. However. If other influences stay the same. For example. Remember that supply and demand curves vary the price of the good in question while keeping everything else the same . by assumption. but it does affect the demand for apples. For many consumers. In our case. In the following chart we show the effect of a generic reduction in demand while supply is held constant:
On the other hand. It’s hard to see how the bumper orange crop would directly affect the supply schedule of apples. What effect. all that happens is we move along the demand curve for apples . this can indeed shift the entire demand curve for apples (to the left) .164
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Example 3: Demand Decrease
Let’s continue with the example above. doesn’t translate into a bigger apple crop among the major orchards . so we’ll assume it stays the same . peanut butter is a complement to jelly . this is a subtle point that sometimes confuses people who are new to the economic way of thinking . if we assume that the apple orchards experience a normal year? the perfect combination of sunshine and rainfall in Florida. the flow of cause-and-effect runs like this: the unusual weather leads to a bumper crop of oranges in Florida. and assume that great weather in Florida has yielded a bumper crop of oranges . the lower price of oranges doesn’t affect the supply of apples. a complement is a good that goes hand-in-hand with another . this means the price of oranges falls . it does make sense to think that the Florida weather will affect consumers and their demand for apples. the demand for its substitutes goes down as well . However. when the price of oranges changes. to put it in other words: When the price of apples changes. so one of the elements of “everything else” is the price of other goods. this doesn’t affect the demand for apples. meaning that one or the other can satisfy the consumers’ ultimate objectives (in this case. by shifting it to the left .
4
.

Lesson 1 Supply and Demand 1:
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P s P1
P2 D2 Q2 Q1
D1
Q
Market for Apples
Example 4: Demand Increase
suppose the actor Robert Pattinson moves into an apartment complex . there are plenty of consumers (mostly female) who would love to live in the same building as the Twilight star . the fact that he now lives in the building would increase the market demand for apartments in that complex:
. and Pattinson’s decision to rent one of the units presumably won’t make the landlord decide to rent out fewer units . the supply of apartments in the building is unchanged. What will be the likely effect on the rental price of the apartments in the building? In this example the analysis is straightforward . the owner of the building can’t sell more units than physically exist. On the other hand.

We will not go down this route because it would involve more graphical analysis .166
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P P2
s
P1 D1
D2
Q1. loud parties. only the price has increased.
A standard economics textbook will usually distinguish between short-run and long-run supply curves . but in our example.5 the graph above also shows that if the price falls low enough. the owner of the building doesn’t bother renting any units out to tenants . but also to show the possibility of a fixed (unchanging) supply . he prefers to keep the building empty and avoid the headaches of dealing with customers who complain of no hot water.
5
. We are taking the opportunity in this example not merely to show the effects of a demand increase. an increase in demand moves price and quantity up. Instead. With a more typical supply curve. even at a relatively low price the landlord is willing to rent out all the units . and so on .Q2
Market for Apartment units
Q
the only complication in our diagram above is the odd-shaped supply curve . since the quantity of apartments cannot increase. But since the whole point of owning the building is to make money. at least not anytime soon .

a reduction in supply and demand at the same time can make the equilibrium price go up or down:
We say eventually the supply curve will shift left because it’s possible that the most paranoid of leather shoe owners try to unload their inventory the day of the announcement. What happens when a change has significant impacts on both supply and demand at the same time? For example. What will happen to the equilibrium price and quantity of leather shoes? the new report will (eventually) cause the supply curve of leather shoes to shift to the left . looking at producers who stay in business and continue to sell shoes months after the initial announcement . safer jobs . at whatever price they can get . But for obvious reasons. making the supply curve shift left . the medical report will also significantly affect the demand for shoes. this technically would constitute a rightward shift in the supply curve . but a minor impact on the other . But even if they merely hire others to sell the shoes. they won’t be as eager to handle as many pairs per day . they will still have to pay higher wages as workers prefer to take other. suppose that a new medical report shows that leather shoes pose serious health risks to those who come in frequent contact with them . but we don’t know what will happen to the equilibrium price of leather shoes . we can confidently say that the equilibrium quantity will decline. shifting it to the left as well .6 If the entrepreneurs are directly involved with handling the shoes. the higher wages of workers will raise the expenses of selling shoes. But in the text we are focusing on the more permanent situation. but the leftward demand shift would tend to lower it . Generically speaking.Lesson 1 Supply and Demand 1:
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Example 5: A Simultaneous Change in Supply and Demand
In the previous examples we have analyzed situations where a change clearly had a large effect on either supply or demand. the leftward supply shift would tend to raise the price. Only if we had exact numbers could we say which effect would be larger .
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. In this case.

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In other words. in a given exercise you will be able to decide (a) that the quantity definitely goes up. but then the other item’s movement will be uncertain . but you won’t know for sure which way the price moves. either price or quantity will move in a certain direction without a doubt. In each case.168
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P
s2 s1
P2 P1 D1 D2 Q2 Q1
Market for shoes
Q
or P s2 s1 P1 P2 D1 Q
D2 Q2 Q1
Market for shoes
In the exercises accompanying this lesson you will work through other combinations of changes in supply and demand that occur at the same time .

while a decrease in price will lead producers to sell fewer units. • Supply and demand schedules (and graphs or “curves”) illustrate the hypothetical effects of keeping every other influence the same. while a decrease in price will lead them to buy more units. but you won’t know about the price. (c) that the price definitely moves up. it is simply a framework for economists to organize their thinking. then an increase in the price will lead producers to sell more units.Lesson 1 Supply and Demand 1:
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Lesson Recap •••
• Economists use supply and demand to explain market prices and the amounts of goods and services produced.
(b) that the quantity definitely goes down. but you won’t know which way quantity moves. but you won’t be sure which way the quantity moves . Supply and demand aren’t “theories” but instead provide a mental framework for understanding how changes in the economy will affect prices and amounts. • The Law of Supply says that if other influences stay the same. or (d) that the price definitely goes down.
. and allowing only the price of the good to change. this isn’t a “theory” about what things influence people in the economy. The Law of Demand says that if other influences stay the same. then an increase in price will lead consumers to buy fewer units. To repeat.

while a higher price will lead them to buy fewer units . and the number of units that consumers want to purchase at each hypothetical price . Demand curves are “downward sloping.170
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new Terms
Demand: the relationship between the price of a good (or service). Law of Demand: If other influences stay the same. supply curves are
. Supply curve: A graphical illustration of the supply relationship. Demand curve: A graphical illustration of the demand relationship. sometimes a generic demand curve is drawn as a smooth. with price placed on the vertical axis and quantity on the horizontal axis . sometimes a generic supply curve is drawn as a smooth. curved line or even as a simple straight line . with price placed on the vertical axis and quantity on the horizontal axis .” meaning that they start in the upper left and move down and to the right . Demand schedule: A table that illustrates the demand relationship either for an individual or a group . Supply: the relationship between the price of a good (or service). curved line or even as a simple straight line . and the number of units that producers want to sell at each hypothetical price . either for an individual or group of producers . then a lower price will lead consumers to buy more units of a good (or service). Supply schedule: A table illustrating the supply relationship.

at various possible prices .Lesson 1 Supply and Demand 1:
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“upward sloping.)
. Equilibrium price / market-clearing price: the price at which producers want to sell exactly the number of units that consumers want to purchase . Reduction in supply / leftward shift in the supply curve: A situation in which a change besides the price of a good (or service) causes producers to reduce the number of units they want to sell. Shortage: A situation where consumers want to buy more units than producers want to sell . the equilibrium price occurs at the intersection of the supply and demand curves . On a graph. On a graph. the equilibrium quantity occurs at the intersection of the supply and demand curves . and consumers want to buy. this occurs when the actual price is below the market-clearing price . this occurs when the actual price is higher than the market-clearing price . On a graph. at various possible prices .
Law of Supply: If other influences stay the same. an increase in supply or a rightward shift in the supply curve. Surplus / glut: A situation where producers want to sell more units of a good (or service) than consumers want to purchase . Equilibrium quantity: the number of units that producers want to sell. at the equilibrium price . this change causes the supply curve itself to move to the left . occurs when a change causes producers to increase the number of units they want to sell. then a higher price will lead producers to sell more units of a good (or service). (In a similar way. while a lower price will lead producers to sell fewer units .” meaning that they start in the bottom left and move up and to the right .

this change causes the demand curve itself to move to the left . (A reduction in the price of hot dogs will probably cause an increase in the demand for mustard . For example. A change in the price of one good tends to cause a change in the same direction in the demand for a substitute . A change in the price of one good tends to cause a change in the opposite direction in the demand for a complement .) Complements: Goods (or services) that consumers use together . On a graph. (A reduction in the price of Coke will probably cause a reduction in the demand for Pepsi . hot dogs and mustard might be complements if someone goes to the store in preparation for a cookout . For example.)
. Coke and Pepsi might be substitutes if someone goes to the store looking to buy soda . Substitutes: Goods (or services) that consumers use for similar purposes .172
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Reduction in demand / leftward shift in the demand curve: A situation in which a change besides the price of a good (or service) causes consumers to reduce the number of units they want to purchase. at various possible prices .

to market demand and supply schedules? 4. How do you go from individual demand or supply schedules. 5. Why does the text say that demand is a snapshot in time? 3. If supply increases while demand decreases.Lesson 1 Supply and Demand 1:
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sTudy QuesTions
1. Explain how the market process tends to push prices toward their equilibrium levels. what can we say about the change in (equilibrium) price? What about the change in (equilibrium) quantity?
. Why does the text say that supply and demand can never be proven false? 2.

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and is also usually quoted on a yearly basis . the loan carried an 8% annual interest rate . In our example. essentially.000 and the lender has earned $80 in interest . Lenders must be compensated (with interest) to give up money available to them now.080 back one year later. the reason borrowers are willing to pay interest is that they
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. the principal is $1. which is the interest expressed as a percentage of the principal. For example.000 and receives $1. the subject of interest. if someone lends out $1. usually people discuss the interest rate.A d vA n c e d L e s s o n 1 2
Interest. can be one of the most complicated areas in economic theory . On the other hand.
Interest: It’s About Time
As we have already learned in Lesson 10. interest has to do with time . In the present lesson we will obviously just cover the basics . • The pros and cons of going into debt. in exchange for a promise to be paid back with money not available until the future . and Debt
In this lesson you will learn:
• The function of interest in a market economy. • Common types of credit transactions. and the explanation of how markets determine particular interest rates. Credit. interest is the amount of money paid to a lender above and beyond the return of the principal .

interest rates for varying time durations or maturities allow businesses to keep track of their books for operations that unfold over several years (not countries) . rather than having to put off their purchases until the future . For example.05 = $100 . in order to receive an ironclad claim on a $100 payment in exactly one year . $100 .s .
. nobody would give up a $100 bill today. well.” A normal exchange rate shows how many current u . the “market price” of a $100 bill is. except under very unusual circumstances. the market interest rate shows us exactly what the discount on future dollars is.s . whereas an interest rate shows how many “2010” us dollar bills trade for one “2011” u . A business firm needs to use exchange rates if it operates in several countries. the interest rate tells us how much the market price of a current dollar is. or (equivalently) what the premium on current dollars is . except that the two currencies are “current u .1 In a sense. We know that in practice. the interest rate is an exchange rate between currencies. then the firm’s accountants will need to translate the three currencies into a common denominator (presumably u . people would pay about $95 .s .176
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value having money (and the things it can buy) right now.24 x 1 .s . at an interest rate of 5%.00 . By the same token. dollar bill. dollars . in exchange for receiving the same $100 bill back in 12 months .s . then pays American workers to process the materials during
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You can check that $95 . A positive interest rate goes hand in hand with time preference. people pay less than $100 today. which is the desire (other things equal) to enjoy goods sooner rather than later . compared to a future dollar . If the firm buys raw materials from u . in order to keep its accounts in a common denominator .s .24 today. For example. and finally sells the products in the united states for dollars. suppliers in 2010. dollar bills trade for one euro or Mexican peso. dollars” and “future u . if the current year is 2010 . in order to receive a promise—even a very reliable promise from a trustworthy borrower—of a future payment of $100 . dollars) to tell if the business is making a profit . But how much right now is an ironclad guarantee that a crisp $100 bill will be delivered in exactly one year? It’s certainly not worth a full $100. if a firm buys certain Chinese components priced in yuan. Right now. pays pesos to workers in Mexico to assemble the parts into finished goods.

the higher the interest rate.Advanced Lesson 12: Interest. Credit. a low interest rate gives a “green light” to entrepreneurs to start longer production processes . and Economic Growth
Remember that in Lesson 10 we saw how an increase in savings allows more investment and faster economic growth . Investment. interest rates guide entrepreneurs to invest their limited resources efficiently . in the hopes of receiving revenue at some far future date . and finally sells the finished goods gradually during the course of 2012. imagine an initial scenario where the interest rate is 8% . We are now in a position to show how the market interest rate helps this process . then the higher the interest rate. the less profitable such an operation will be . the firm’s accountants cannot ignore the time element for the various expenditures and revenues . and Debt
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2011. “Did we turn a profit?” It is important to point out that the higher the interest rate. We can use supply and demand curves (as discussed in Lesson 11) to illustrate this initial equilibrium interest rate for the loanable funds market:
.
Savings. the dollars paid for materials in 2010. but profitable at a lower interest rate . Market interest rates help them determine the appropriate discount to apply. the bigger the “penalty” on the duration of an operation. and so the accountants need to discount the later money . First. requiring inputs of labor and raw materials for many years before the finished product emerges. even if we keep all of the prices for materials and the final product the same. If there is a very long operation. have a higher market value than the dollars received from customers in 2012. Like all other market prices. in order to look at the entire three-year operation and decide. and the greater the encouragement that the market gives to entrepreneurs to quickly convert their resources into final goods for their customers . as well as the dollars paid for labor in 2011. this is because the entrepreneur running the operation will spend money today and for many years. On the other hand. the more present-oriented business operations will be . a given project can appear unprofitable at a high interest rate.

where the lenders want to provide exactly as much money in loans as people wish to borrow . which is the same thing as the interest rate . (Convince yourself that at higher interest rates—other things equal—lenders would want to supply more funds while borrowers would demand fewer funds . In our example. as borrowers would seek to borrow more (measured in total dollars) than lenders collectively would be willing to supply . the y-axis refers to the price of the loan.
.) On the other hand. if the interest rate were below 8% in our chart above. it is the price of borrowing money . only at an interest rate of 8% do we have an equilibrium. some people say that interest is the “price of money. With our supply and demand curves as shown above. after a person borrows and repays the loan principal. then lenders would want to lend out more money than borrowers wanted to borrow . he still has to fork out an additional $8 fee . the equilibrium interest rate equates the quantity demanded of borrowed money with the quantity supplied of money to be lent . to borrow $100 for a year carries a price of $8. then there would be a shortage of loanable funds.178
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P 10% 8% 6% s
D Q* Market for Loanable Funds Q
notice that the x-axis on the above refers to the total amount of money being borrowed (demanded) and lent (supplied) . If the interest rate were too high.” but that is inaccurate.

). In Lesson 10 we already saw that when people in the community on average reduced their present consumption (spending on restaurant meals. suppose that the community’s increased willingness to save leads to a fall in the rate of interest (the price of a loan) down to 6%. electronics goods. But now we see how the market interest rate plays a role in helping the entrepreneurs adjust to the new preferences of their customers. vacations. the lower interest rates send a signal to entrepreneurs to engage in longer-term projects that are now profitable . etc .
P 10% 8% 6% 4% Q1 Q2 D1 Q s1 s2
Market for Loanable Funds
We now have a more complete understanding of the process described in Lesson 10 . and Debt
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now what happens if most people in the community decide to save more? In a supply and demand framework. the suppliers are willing to bring more of their saved funds to the market to lend out to borrowers . and an increase in the total amount of dollars lent and borrowed . When a community saves more in general. we illustrate this change by shifting the supply curve of loanable funds to the right. Credit. tools. and other capital goods that would eventually boost future output . because at every hypothetical interest rate (price). this frugality freed up physical resources and allowed for increased investment in machinery.
.Advanced Lesson 12: Interest. this pushes down interest rates and leads to more total funds available for borrowers .

At the time of the repayment. it’s true. In the same way. or a stream of money payments at various specified dates .e . one party trades money that he has saved in exchange for a claim (or a promise) from another party that she will give a specified payment of money at a future date.2 In the examples we discuss in this section. most governments have institutionalized the practice of fractional reserve banking. in which banks really do create new money when they advance a loan . credit transactions per se do not tend to “push prices up” as many people believe .
2
In modern times. but the influx of money gives that much more spending ability to the lender .. the borrower must restrict his spending in order to pay back the principal (plus interest). the company) . credit transactions do not create money. the borrower is able to spend more in the present than he otherwise would be able to. a simple credit transaction doesn’t create money either—the lender hands over money in exchange for an I .3 When someone buys a pack of gum.180
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and guides them into shifting the entire structure of production to become more future-oriented . Because of this fact.
Bonds
When a company wishes to borrow money. it sells a bond which is a legal claim entitling the bondholder to a stream of cash payments from the bond issuer (i .O . from the borrower .” you can break the overall transaction into two separate events: First the merchant lends money to the customer on certain terms. money isn’t created. and then the customer uses the borrowed money to buy merchandise from the merchant .u . they simply shift money from one holder to another .
Common Credit Transactions
In a simple credit transaction. but the lender can spend that much less . there is nothing mysterious behind
note that if a merchant allows a customer to buy merchandise “on credit. this is a complex topic that we will not discuss in this introductory book .
3
. the buyer hands over money in exchange for the pack of gum .

the bank is an intermediary between the ultimate lenders and borrowers in the market . now we understand the function of a credit intermediary such as a bank . it is simply a standardized contract in which a company borrows money from someone else in the community . the bank acts as a borrower. in many cases borrowers use the services of a credit intermediary. such as a bank.000 in exchange for the couple’s signatures on a loan contract. when depositors lend their funds to the bank (and earn a certain interest rate on their deposits) . the problem is that the individual saver doesn’t really know the couple very well. and even if the couple is hardworking and sincere. People in the community are willing to deposit their money with the bank. ultimately.000 . second. the interest rate they charged would be quite high . First. Consider a young couple who want a mortgage to buy a new house for $200.
Banks
When an individual wants to borrow money. or if they did. a job layoff or medical condition could make them default on the loan . and Debt
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“issuing” a bond. Credit. the person “buying the bond” is really doing nothing more than lending money (the bond price) in exchange for the company’s official promise to make interest payments at regular intervals and eventually return the principal . they are going to borrow the money from various savers scattered throughout the community . But if the prospective borrowers went knocking door to door. However. as well as provide an income to the entrepreneur(s) running the bank . A successful bank is able to earn enough money on the spread (the difference between the interest rate it charges borrowers and the interest rate it pays to depositors) in order to pay its staff and other expenses. they probably wouldn’t find many takers. One of the main reasons the bank is able to maintain this spread is that different borrowers have different degrees of credit risk. trying to find 200 people who would each put up $1. he can make individual arrangements with various people . the bank uses these funds to act as a lender to people in the market who wish to borrow from the bank (and pay a certain.Advanced Lesson 12: Interest. because it is much less likely to lose their savings than any individual
. higher interest rate on their loans) .

so long as the bank has properly estimated the credit risks of its various borrowers. here too no new money is created. allowing the cumbersome two-step process to be executed in a matter of seconds . On the contrary—assuming the banks have done their jobs properly—the loss in contractual mortgage payments is spread evenly among all the lenders. the interest rates it charges in its various mortgage and other loan contracts will have already reflected the riskiness of each borrower . but to hundreds or thousands of home buyers. As with the other transactions discussed above. When the savers in a community lend to the borrowers through credit intermediaries such as banks. a pair of shoes at the mall and swipes her credit card at the register. the familiar use of plastic cards is just a matter of convenience. the bank can afford to lend to the couple. the bank reduces the damage of any particular loan default .
Credit Cards
A popular form of credit transactions nowadays involves the use of a credit card . In principle. reflected in the fact that they earn a lower interest rate on their bank deposits than the ultimate borrowers are paying on their mortgages . say. By making mortgage loans not just to one couple. because it has experts whose job is to evaluate the likelihood that the couple will make their mortgage payments on time . the bank will absorb the expected number of delinquencies and defaults as part of the cost of doing business . the transaction is equivalent to one where a representative of the credit card company walks into the store.182
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borrower . what actually happens is that the credit card issuer pays money to the store.
. that loss doesn’t fall entirely on an unlucky 1% of the lenders who lose their life savings . hands the customer the money in exchange for a signature promising to pay it back with interest. and then the customer hands the newly-borrowed money to the store clerk . thus they are willing to lend at a much lower contractual interest rate than they would have insisted from the couple trying to buy a house . If. When a customer buys. it allows the risks to be pooled and distributed more uniformly . 1% of the couples borrowing money for a home purchase end up defaulting on the mortgage payments. say. and then records the loan on the customer’s account . On the other hand.

In a free market.” Indeed there is much truth to this warning. there are several companies that provide the service of keeping up with borrowers’ debts and repayment history .Advanced Lesson 12: Interest. often the object being purchased with the loan . and Debt
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As with other lenders. Credit. in which the house (and land on which it sits) serves as collateral. When someone applies for a credit card. Although these are credit transactions too. Applicants with “good credit” (meaning a high credit score) have shown that they are responsible and can be trusted to pay off their credit card balances . will have “poor credit” (meaning a low credit score) and may not be approved for a new card. When it comes to consumer purchases on credit. so when some criticize the wisdom of credit purchases. someone who has never had a credit card or otherwise borrowed money may find it difficult to secure a card with a high credit limit. and has a history of missing payments. or will be granted a card but with a very modest credit limit . these companies sell lenders “scores” on each applicant. and the consumer thought at the time of purchase that the benefits of the immediate availability outweighed the costs of having to pay back the loan (with interest) in the future .” and that “if you can’t pay cash for something. an applicant who has a high amount of debt with other companies. to make it easier for the lender to determine if the borrower is likely to repay on time . if a consumer chooses to buy on credit this is a voluntary action. because there is no history that the issuer can review to see how this applicant handles debt . then you can’t afford it . A secured loan has collateral backing it up. or a car loan in which the vehicle is the collateral . voluntary choices . Ironically.
The Pros and Cons of Debt
some people understandably warn that “you should never get into debt. credit card issuers must be careful when lending money to borrowers . the issuing company will review the applicant’s credit history to judge the likelihood that the applicant will pay back any borrowed money . it certainly changes
. they are relying on the fact that people can often regret their previous. typical examples include a mortgage. there is an important distinction between a secured versus an unsecured loan . and many people would testify that excessive credit card debt ruined their lives . On the other hand.

On the other hand. the distinction between a secured and an unsecured loan doesn’t match up perfectly with the different types of borrowing behavior . with another method being the issuance of stock. After the factory is up and running. because there are no assets “backing up” the loans . so long as things go according to plan. It’s still the case. the corporation’s revenues are higher than they otherwise would have been. a dentist could use her personal credit card in order to purchase a new computer for her office receptionist . that a person’s credit report will penalize him or her more heavily if a given amount of debt is unsecured. and then use the money to finance a vacation cruise .
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strictly speaking.184
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our evaluation of the wisdom of a large increase in debt if we find out that there is a valuable new asset being acquired .000 to buy a new car could sell the car and pay off most of the remaining debt if his circumstances changed . and out of this surplus the corporation can make its periodic interest payments to the new bondholders. and labor services from workers . and eventually eliminate the debt completely by paying back the principal . if someone borrowed $10. Individuals too can borrow productive debt. In many respects. there would be nothing (except memories) to show for it down the road.4 the most obvious example of what is called productive debt occurs when an entrepreneur borrows money in order to expand his or her business operations . and uses the lent funds to purchase raw materials. if they receive loans to put themselves through college or medical school . equipment. For example. however.000 to take a cruise. what happens is that the corporation borrows $10 million from savers in the community. whereas someone borrowing $10. so that paying back the loan will not be a burden . For example. a large corporation may decide to issue $10 million in new bonds in order to finance the construction of a new factory . debt is simply one way that businesses can raise funds for new investment spending. a topic we address in Lesson 14 . For example. someone could get a secured loan with his car (which he previously purchased with cash) serving as the collateral. the essential feature of productive debt is that the borrowed money is invested in order to increase the borrower’s future income.

a higher debt load forces the borrower to devote more of his income to paying interest (or “finance charges”) to the lender. debt allows the borrower to make purchases sooner. If people are impatient. and Debt
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Lesson Recap •••
• In a market economy.
. then the interest rate will be high and producers will invest in relatively quick projects. with producers’ investments in projects that take shorter or longer to complete. • Common credit transactions include cases where corporations borrow money by issuing bonds. interest rates help to coordinate consumers’ preferences to enjoy goods sooner versus later. leaving less income available for enjoyments in the future. • There are pros and cons of going into debt. In some situations taking on debt can be “productive” if the borrowed money is invested rather than spent on immediate enjoyments. On the positive side. then the interest rate will be low and producers can invest in longer projects. Credit.Advanced Lesson 12: Interest. If people are willing to postpone immediate gratification by saving. On the negative side. and individuals pay for purchases using credit cards. homebuyers take out mortgages from banks.

Exchange rate: the “price” of one currency in terms of another.
. than the bank has cash in the vault . a gauge of people’s impatience to receive enjoyments . all of the bank's customers have more money on deposit. in the hopes of receiving back the principal plus interest in the future . (Loans and their corresponding bonds can have shorter or longer maturities . because it will not be received until the future . Fractional reserve banking: the typical practice where banks do not keep all of their customers' deposits in the vault . or how many units of one currency will trade for one unit of another currency . while the other person promises to give up something (such as money) in the future . Maturity: the time duration of a specific loan. and the interest rate that applies to it . which is a legally binding promise to repay borrowed money plus interest .) Loanable funds market: the market in which lenders give money to borrowers at an agreed-upon interest rate . Bond: A corporation’s IOu. Discount: the percentage by which the value of a unit of money is reduced.186
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new Terms
Time preference: the degree to which people prefer to consume sooner rather than later. Credit transaction: An exchange where one person gives up something (such as money) today. the buyer of a bond gives money to the corporation today. In other words.

compared to the interest rate it pays to its lenders or depositors . Mortgage: A special type of loan in which the borrower buys a house (or other real estate) with the funds . Bank: A common credit intermediary.Advanced Lesson 12: Interest. because they have not been keeping up with their required payments . Spread: the difference between the interest rate that a credit intermediary (such as a bank) earns from its borrowers. and Debt
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Credit intermediary: A person or organization that is the “middleman” between lenders and borrowers .
. Credit risk: the likelihood that a borrower will be unable to pay back a loan . which takes deposits from many different lenders and makes loans to many different borrowers . Default: A situation when a borrower stops making repayments on a loan . Depositors: People who give their money to a bank . Credit card: A device that allows the borrower to achieve virtually instant loans from the credit card company when making purchases . A positive spread allows the credit intermediary to earn income from its activities. so long as it has correctly estimated the likelihood of default by its borrowers . usually the property serves as collateral for the mortgage . Credit. Delinquencies: Cases where borrowers are not in good standing with the lender (such as a bank). Credit history: A person’s record of borrowing and repayment behavior .

the advantage to the borrower is that none of his or her other assets can be seized (or “repossessed”) in the case of default . If the borrower defaults. (For example.”
. Ideally. the lender can take control of the house or car . the extra income from the investment spending will allow the borrower to make the interest payments resulting from the increase in debt. Credit limit: the maximum amount of money that a person can borrow from a pre-approved source (such as a credit card) .) Productive debt: Debt used to finance investments . the lender has no other options .188
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Credit score: A number that an agency will assign to a person based on his or her credit history. Secured loan: A loan that has an asset (such as a house. in case the borrower defaults . car. the advantage to the borrower is that the interest rate is lower than it would be for a comparable unsecured loan . Collateral: An asset that a borrower “puts up” when applying for a loan . which helps potential lenders decide on the riskiness of lending money to the person . meaning that if the borrower fails to make his or her payments on schedule. the lender may take possession of the collateral as compensation . if a borrower wants money to buy a house or a car. Unsecured loan: A loan that has no collateral serving as a backup . so that the extra borrowing “pays for itself .) pledged as collateral. etc . these items themselves can serve as the collateral. If the borrower defaults.

*What is the connection between interest rates and currency exchange rates? 3. Why is the first section titled. Why does a low interest rate give a “green light” to long production processes? 4. What is “productive debt”?
. What is exchanged in a credit transaction? 5.Advanced Lesson 12: Interest. Credit. and Debt
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sTudy QuesTions
1. “Interest: It’s About Time”? 2.

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1 which in turn will lead consumers to buy fewer oranges and cartons of orange juice .A d vA n c e d L e s s o n 1 3
Profit and Loss Accounting
In this lesson you will learn:
• The distinction between interest and profit. More accurately. For a different example. if people become more concerned about having straight teeth.
Profit and Loss Guide Entrepreneurs
n previous lessons we have shown how market prices guide the actions of everyone in a market economy . a cold snap per se doesn’t cause prices to rise. For example. and then their new subjective valuations interact with the original subjective valuations of buyers in the market. which will ultimately lead to more students
We are speaking loosely .”
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. the demand for braces will rise. and even a reduction in physical supply doesn’t cause prices to rise . technically. • The limits of profit and loss accounting. if an unexpected cold snap decimates the orange crop. • The social function of profit and loss accounting. then the sudden drop in supply will cause the prices of oranges and orange juice to rise. we should say that the cold snap changes the situation of the orange producers. But it is obviously much simpler to say. such that the equilibrium price of oranges is higher than it was before . “supply fell so the price rose .

When more entrepreneurs flock into a highly profitable activity. raw materials. electricity bill. while those that cause losses will repel entrepreneurs . In short entrepreneurs estimate whether their proposed course of action will yield a profit or a loss. entrepreneurs estimate the amount they must spend on their ingredients or inputs (hired workers. where this calculation involves current and future market prices . etc . leading to lower prices for the workers.2 Market prices act as signals about underlying changes in both the physical world and subjective preferences. these examples should be interpreted as tendencies that will only lead to actual changes so long as other things remain equal .). the diminished supply of the finished good or service
As always. and other items used in this particular activity . even if the earnings of orthodontists rise because of a higher demand for braces. On the other hand. activities that generate high (monetary) profits will attract more entrepreneurs. allowing people to adjust their behavior in light of new realities . and entrepreneurs who are originally in the industry will either scale back their operations or abandon them and move to a different line of work . the gap between the two sets of prices— which was driving the originally high profit margin—tends to shrink. their efforts to buy the necessary inputs cause their prices to rise. the entrepreneurs’ total demand for the necessary inputs drops. so that the monetary profits disappear as well .192
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choosing a career in orthodontics . raw materials. the reverse occurs when an activity is plagued by recurring losses . entrepreneurs do not respond to particular prices but rather to the difference between certain prices . In a market economy with open competition. If the drop in orange supply were accompanied by a new report showing that orange juice causes cancer. while the increased output of the finished good or service causes the price to the consumer to fall . as entrepreneurs adjust to the situation . On the other hand. then the price of orange juice might end up falling . it’s still possible that fewer students go into the field if a popular movie depicts orthodontists as having dirty and unfulfilling jobs . and then forecast the total revenues they will receive from customers when selling their finished products or services . new entrepreneurs will shy away from the industry. Generally speaking. there is a tendency for monetary profits and losses to be whittled away over time.
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and the input prices have fallen enough. which is certainly more money than she started out with . if she originally borrowed the $10. All she has to do is wait until December when she can sell the 100 mature trees for an average of $30 apiece .000 investment into $3. and even (c) the payments that he makes to the utility company for the electricity his operation requires . and the associated “price” of this investment as expressed by interest payments . Only if the revenues he earns from selling television sets is great enough to cover these expenses will the operation be profitable . our tree entrepreneur needs to consider interest payments . Can we conclude that the Christmas tree venture was profitable? Before answering the question. she tries to pay off the
. he must take account of (a) the wages he pays to his assembly line workers. it’s easiest to use a concrete illustration . then she actually lost money on the whole arrangement . (b) the prices for the metals and plastics that he buys in bulk. suppose someone can spend $10.000 + $7.300 . the entrepreneur would have turned her original $10. For example.Advanced Lesson 13: Profit and Loss Accounting
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tends to raise the price that the consumer must pay . up until now we have ignored a very important “input” into any long-term business operation: the financial capital invested in it. the new owner doesn’t need to spend any more money .000 from someone at a 5% annual interest rate. After the trees have all been sold. From the revenue from the trees and the land sale. this process continues until the finished price has risen enough.000 in January buying a plot of land that contains a young crop of Christmas trees . However. to see how interest payments factor into profitability. For example. she can also sell the bare land for $7.300 in hand.300.
Interest versus Profit
We have explained that when an entrepreneur calculates whether or not his business is turning a profit. if he runs a factory that produces television sets. he must consider the prices of the various inputs he uses in his operations . so that the remaining entrepreneurs no longer suffer losses from producing the good or service in question . With her $10.300 = $10.

versus the out-of-pocket expenditures on inputs such as labor and raw materials . in which case the interest expense would not be a full $500 .. this is because a portion of what is called the gross profit (or accounting profit) must go to pay interest on the financial capital invested in the business . we assumed that the owner didn’t have to do any work except wait 12 months for the trees to mature . meaning that interest rates are positive .000 out of her savings and purchased a 12-month corporate bond yielding 5%—and if the woman viewed this investment at least as “safe” as plowing her money into a crop of Christmas trees—then in a sense she would be $200 poorer if she invested the money in the land with the young crop of trees . it is not true that competition will completely whittle away the gap between the revenues an entrepreneur receives from selling his product or service. But in the Christmas tree example. When we say that a high profit attracts more entrepreneurs into an industry. and finds that she still owes a balance of $200 . to compute net or economic profit .
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Most economists would also include the implicit salary that the entrepreneur “pays herself” as an item to be subtracted from gross or accounting profit. We need to keep this fact in mind when discussing competition and its impacts on profit margins .194
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creditor who lent her the money. In Lesson 12 we learned that people usually attach a higher value to current dollars (and other forms of money) over future dollars. For example.e . In this case the monetary “loss” would not show up in the official records compiled by her accountant. even in the long run. back in January if the woman could have taken $10.
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. because the $500 in forfeited interest on the corporate bond would be an opportunity cost.3 even if the tree entrepreneur uses her own saved funds.4
We’re ignoring the slight complication that she can pay back most of the loan before 12 months have actually passed. the profit when an implicit interest payment on invested capital has been included as one of the “inputs” into the operation . i . to be correct we mean high net profit (or economic profit). if alternative investments yielded a rate of return higher (and less risky) than the implicit 3% return in the Christmas tree business . most economists would say she still “lost” money on the deal. rather than an explicit out-of-pocket expenditure .

In reality. yet the boss doesn’t allow it. “society” doesn’t decide anything. Whatever the social system in place. market prices are formed when individuals engage in voluntary exchanges with each other . there are necessarily fewer resources available to produce everything else . everyone in society obeys the rules of private property which assign ownership claims to particular units of resources . “Would the world be a better place if there were more medicine?” the relevant question is. for example.Advanced Lesson 13: Profit and Loss Accounting
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The Social Function of Profit and Loss Accounting
Many naïve observers of the market economy dismiss concern with the “bottom line” as a purely arbitrary social convention . When scarce resources are devoted to producing more bottles of aspirin. In this context. because to do so would “lose money . say. every economic decision involves tradeoffs . In the pure market economy that we are studying in this section of the book. they often define the economic problem as society’s decision on how to allocate scarce resources into the production of particular goods and services . Because of scarcity. to these critics. the resulting prices in turn give entrepreneurs the ability to calculate (expected) profits and losses from various possible activities .” On the other hand. It is the interaction of property owners in voluntary trades that “determines” what goods and services get produced. it seems senseless that a factory producing. the regrettable fact is that the material world is one of scarcity—there are not enough resources to produce all the goods and services that people desire . not profit!” such critics do not appreciate the indispensable service that the profitand-loss test provides to members of a market economy . Observers who are outraged by this system may adopt the slogan: “Production for people. medicine or shoes for toddlers stops at the point when the owner decides that profit has been maximized . It would certainly be physically possible to produce more bottles of aspirin or more shoes in size 3t. many apparently superfluous gadgets and unnecessary luxury items are produced every day in a market economy. It’s not enough to ask. individual members of society make decisions that interact to determine the ultimate fate of all the resources at humanity’s disposal . but the signals provided by market
. because they are profitable . “Would the world be a better place if there were more medicine and less of the other goods and services that would have to be sacrificed to produce more medicine?” In standard introductory textbooks.

” what that ultimately means is that consumers were not willing to spend enough money on its finished output. and kitchen shelves were coated
. They determine what should be produced and in what quantity and quality.
The Customer Is Always Right
The real bosses [under capitalism] are the consumers. suppose a successful builder dies and passes on his business to his foolish son . the entrepreneurs offer money to the owners of labor services. they desert their old purveyors. the son gets the bright idea to build new apartment buildings covered with pure gold . They make poor men rich and rich men poor. the entrepreneurs then use these inputs to produce goods and services which they sell to consumers for money (see figure on the next page) . changeable and unpredictable. let’s work with a silly example . p. It might be useful to step back and look at the big picture . As soon as something is offered to them that they like better or is cheaper. Bureaucracy. — Ludwig von Mises. hallways. decide who should own the capital and run the plants. Their attitudes result either in profit or in loss for the enterpriser. by their buying and by their abstention from buying. They are full of whims and fancies. They do not care a whit for past merit. 227
When a particular entrepreneurial venture goes “out of business. capital goods. He correctly estimates that there would be high demand for apartments where the elevator. and natural resources .196
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prices—and the resulting calculations of profit and loss—help the property owners make informed decisions . to cover the offers the entrepreneur needed to make in order to bid the scarce inputs away from other entrepreneurs who wanted the inputs for their enterprises . to see this principle more concretely. They are no easy bosses. They.

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.

It’s ultimately not the owners of gold mines nor the captains of industry who determine how gold will be used in a market economy . “It’s too expensive to use gold in my business . in conjunction with their demands for silver versus gold-coated necklaces. In fact the son can rent his units for much higher monthly fees than the owners of normal apartments in similar locations . After all. Instead. he is losing incredible amounts of money because of his decision to coat the apartments with gold . the profit and loss system communicates the desires of consumers to the resource owners and entrepreneurs when they are deciding how many resources to send into each potential line of production . In a market based on the institution of private property. and dentists still find it profitable to use gold for fillings . the profit and loss test provides structure to the free enterprise system . and other items.198
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with gold . profits occur when an entrepreneur takes resources of a certain market value and transforms them into finished goods (or services) of a higher market value . the foolish son’s production costs are astronomical . It is the consumers’ demands for normal versus gold-coated apartments. no jeweler would say. he might say. jewelers still find it profitable to buy gold in order to make necklaces and earrings. Without the feedback of profit and loss calculations. and to sell their resources (including the labor services of their bodies) to whomever they wish . these decisions are largely guided by the spending decisions of the consumers . now if we were to interview the son and ask him what happened. the reason gold is so expensive is that other buyers are paying such high prices for it . People are free to start new businesses. this is the important sense in which profitable entrepreneurs are providing a definite service to others in the economy . he won’t be building apartments coated with gold for very long .” Loosely speaking. concrete. For example. even though his revenues are very high. wood. either way. this isn’t the whole story . he must spend hundreds of millions of dollars buying large quantities of gold . His accountants inform him that despite the higher revenues.
. Of course. that leads to the outcome that gold-coated apartments are ridiculously unprofitable while gold-coated necklaces are perfectly sensible . “It’s too expensive to use gold in my business . or he will squander all of his wealth . In addition to the labor. the son will have to either wisen up quickly.” But notice that this can’t be true for all entrepreneurs .

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entrepreneurs would have no idea if they were making economical use of the resources used up by their business operations . is to guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand. and in what quantities—and what articles will not be made at all. costs.
The Social Function of Profits
“In a free economy. but merely guide them . 1979). If there is no profit in making an article. “One function of profits. the rules of accounting are a mental tool similar to the more fundamental tool of arithmetic . the prospect of profits decides what articles will be made.” —Henry Hazlitt. Young students are forced to memorize the times tables. can solve this problem arbitrarily. in brief. and prices are left to the free play of the competitive market. it is a sign that the labor and capital devoted to its production are misdirected: the value of the resources that must be used up in making the article is greater than the value of the article itself. Economics In One Lesson (New York: Crown Trade Paperbacks. in which wages. but most people recognize that there is nothing arbitrary about these “rules”—they are simply shortcuts
. no matter how brilliant. 161–62
The Limits of Profit and Loss Accounting
Profit and loss calculations do not determine the actions of people in a market economy. No bureaucrat. pp.

but they will probably not get very far in life . there would soon be mass starvation . Arithmetic (or mathematics more generally) helps guide people’s decisions. young students learn much more than math—depending on their background. entrepreneurs in a market economy aren’t slaves to profit maximization. but obviously such knowledge only goes so far in what it can say . we have to understand why the workers find it “profitable” to agree to such a shift instead of spending all of Christmas Day with their own families . the owner might hire workers to run the theater while he stays home with his family . these techniques are not arbitrary. someone who owns a movie theater probably won’t close it down during the holiday season. civilization would come crashing down . However. and they express truths about the physical world as well as other people’s (subjective) preferences . entrepreneurs (or their accountants or the programmers who design their business software) must learn the proper way to construct a balance sheet and an income statement to understand if their enterprises are profitable . In this case. they might also memorize the ten Commandments. And if too many entrepreneurs went this route. as acts of charity . or to perform services for free for the indigent. there is nothing “uneconomical” or “inefficient” about such decisions . the crucial point is that financial accounting allows the entrepreneurs to realize just how expensive these decisions are . there are limits to their usefulness . read Aristotle. A similar limitation applies to financial accounting and the profit and loss test . Any particular entrepreneur can choose to ignore the bottom line if he wishes. An entrepreneur is also perfectly free to give discounts to the elderly. simply because the potential revenues are so lucrative . After all. a business owner can close the shop from Christmas eve through new Year’s.200
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to expressing objective truths about reality . Adults are free to ignore multiplication if they want. If too many people decided they no longer “believed in” arithmetic. but he won’t be in business for long .5 Yet this
Of course. In an analogous fashion. in order to become responsible members of society . notwithstanding the tremendous importance of mental tools such as arithmetic and financial accounting.
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. and spend the holidays with his family . and study the French Revolution.

but rather consumer demands for iniquitous ends . it is instead the willingness of so many consumers to spend their money on cigarettes rather than salads . the money prices formed in a market economy allow individuals to put their affairs into perspective. many consumers may be willing to spend large sums of money on things that are immoral. economics does not say. But ultimately it is not the capitalist system that “forces” farmers to plant so much tobacco. and not everything can be reduced to dollars and cents . Critics of this unhealthful outcome really have a problem not with private property per se. However. In terms of a social institution. private property (and its offshoots of market prices and profit and loss accounting) is extremely beneficial to mankind because it provides coherence to economic activities . “Profit makes right . and the resulting profitability of producing these items or services doesn’t wash away their flaws . in order to realize just how much they are ignoring the desires of others when they use their property in particular ways . but with the voluntary choices of smokers . “A movie studio must produce violent films if they make the most money .
. it is not the profit motive per se that is at fault. but strictly speaking economic science does not instruct entrepreneurs to devote their lives to the accumulation of as much money as possible .Advanced Lesson 13: Profit and Loss Accounting
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seemingly deplorable fact—that the profit motive “forces” some merchants to work even on Christmas!—is really just a reflection of how much consumers enjoy going to movies during the holidays .” For example. it is true that large amounts of arable land are devoted to tobacco rather than tomatoes . to recognize this fact is not to say that. even in cases where many people consider certain profitable activities to be immoral. For example. there is more to the good life than earning profits. it probably will be the case that entrepreneurs will enter an industry and produce those things which command the highest profits.” In practice.

and there is nothing “uneconomical” about this decision. accurate profit and loss accounting allows entrepreneurs to make informed decisions about the use of scarce resources. it is a signal that the entrepreneur is transforming resources into goods and services of higher value. If an activity is profitable. it is a signal that consumers would prefer that resources stop flowing into the losing operation. it lets them take into account other people’s preferences about how those resources shall be used.202
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Lesson Recap •••
• Interest refers to the normal return from lending or investing savings in a project. Even so. • Profits and losses help guide entrepreneurs to use scarce resources in ways that best satisfy the preferences of their customers.
. If an entrepreneur is losing money. and go elsewhere to create more valuable goods and services. Economic profit refers to the extra return an entrepreneur earns from a particular project. An entrepreneur may continue operating a business that “loses money” because he gets personal enjoyment from it. over and above the normal interest return on the invested capital that could have been earned on similar projects. which could just as well have been earned in other projects. • Profit and loss accounting can only reflect the monetary aspects of an operation.

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new Terms
Gross profit / accounting profit: the excess of revenues over out-of-pocket expenses . this is what newspapers mean when they report on a corporation's “profits” for a given time period .
. Net profit / economic profit: the portion of gross profits over and above the normal interest return on the invested capital . Economic problem: How to allocate society’s scarce resources (including labor) in order to produce the combination of goods and services that best satisfies people’s preferences .

” 2. as entrepreneurs adjust to the situation. Explain: “In a market economy with open competition. there is a tendency for monetary profits and losses to be whittled away over time. Explain: “Entrepreneurs do not respond to particular prices but rather to the difference between certain prices. Does a market economy force entrepreneurs to do whatever makes the most profit?
.204
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sTudy QuesTions
1. In what sense do consumers—rather than the “captains of industry”—guide the production decisions in a market economy? 5.” 3. specifically the difference between accounting and economic profit? 4. *How does interest relate to profit.

• The difference between corporate debt and equity. n . and there is a total of 1. He and the other shareholders have proportional claims on the assets and income earned by the Acme Corporation . For example. which are legally transferable fractions of ownership of corporations . With the development of the internet. people often refer to “the market” and ask whether it is “up or down . • The social function of stock speculation.
The Stock Market
n everyday conversation.000 shares outstanding. then this person owns 5% of the Acme Corporation itself . such as the new York stock exchange (located at 11 Wall street. You have probably seen frantic traders yelling out bids as stock prices scroll across a large display screen . Purchases and sales of stock shares occur on stock exchanges. new York.” What they mean is not the overall market economy.Y . the stock market is a particular market in which buyers and sellers trade shares of corporate stock. if someone owns 50 shares of stock in the Acme Corporation. it has become much easier for average people to
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The Stock Market
In this lesson you will learn:
• The definition of the stock market. but rather the stock market .) or the London stock exchange .

One way to do that is to sell new bonds to lenders. an existing corporation can raise more capital by selling additional shares of stock (thus diluting the ownership claims of the original shareholders) . Or. and where prices may be extremely volatile. but even here a shopper doesn’t usually see prices for these items change from hour to hour . In this case the existing owner or owners can go public by incorporating the business and selling shares to others in an initial public offering (IPO) . and tax reasons that favor incorporation over other business forms for certain companies . there are various regulatory. the latter move is also called issuing equity. changing from moment to moment as new information hits “the market .”
Why Issue Stock? (Debt versus Equity)
In Lesson 12 we learned that entrepreneurs sometimes borrow money from others in order to accelerate the growth of their businesses . because it confers ownership in the corporation . the individual owner who wants outside funds might ask friends and family for loans. a couple trying to sell a home will list their price and probably wait at least one month before considering a reduction . However. a seller will fix a price and wait a long time to see how many he sells. where billions of individual stock shares may change hands every day. legal. relying on informal contracts and their trust in his character . For example. they usually mean the price at which the last trade was conducted . let’s imagine the Acme Corporation is doing quite well and wants to raise $100 million to expand its operations . In many settings unrelated to the stock market. an alternate method is to raise capital by selling ownership claims to the business . If a business is a sole proprietorship. things are different on the stock market. In this lesson. For concreteness. before adjusting the price . which (say) promise to pay them 5% interest
. our goal is merely to understand the basic distinction between a corporation raising new funds by issuing debt versus stock . A grocery store might update the price it charges for milk or eggs much more frequently.206
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buy and sell stocks (through stock brokerages) without physically visiting a stock exchange . When people refer to a particular stock’s price.

If Acme then issues 2 million new shares at $50 each. recruitment of skilled managers.) there are pros and cons for Acme raising the funds by issuing new debt . Had they properly forecast the fate of their company. so that in the long run the owners of Acme (i . If the $100 million in new funds doesn’t allow Acme to generate at least an additional $5 million per year (on average). meaning that Acme has the contractual ability to pay off the $100 million earlier than the original ten-year schedule specifies. owned by various people in the community . regardless of Acme’s health .) will allow Acme to boost its revenues by more than $5 million each year. and then must make ten annual payments of $5 million before paying out the $100 million and retiring the bonds . For example. the downside of taking on additional debt is that Acme has to pay its creditors (i . and a return of the principal in ten years . it may of course try to roll over the debt by issuing new bonds—this is like refinancing for a homeowner . Acme still has to pay the same fixed 5% interest payments on the borrowed money . the Acme Corporation instead can sell new shares of stock .
1
. they are locked into making the annual $5 million interest payments. the $100 million injection of new funds (to be spent on a new plant.Advanced Lesson 14: The Stock Market
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annually. the bondholders) whether or not the expansion is profitable . advertising. But now that the total number of Acme shares has risen to 4 million. it will raise the desired $100 million in new funds for its expansion .. etc .e . then Acme’s owners will be poorer because of their bad decision . suppose that originally Acme has 2 million outstanding shares. and hence avoid being locked into the 5% rate for the entire time . the proportional ownership of the
We are ignoring such complications as the possibility that Acme’s bonds are callable. Acme gets its desired $100 million right away. meaning the debt issuance will “pay for itself .” that is to say. the increase in Acme’s revenues will allow it to more than cover the interest payments.e .1 Rather than issue new debt. because of their decision to issue debt . under this route. (If Acme doesn’t want to come up with $100 million at that future point.. the shareholders) will be richer. yet once the bonds are sold they can’t avoid their contractual obligations . they would not have agreed to borrow money at a 5% interest rate. If things go as planned. Whether the decision turns out to be just a good one or a fantastic one.

000 shares. As part owners. Acme officials will first have to pay contractual interest payments to their bondholders. For example. then their scope for high returns is diminished but at the same time they can share the pain of losses with more people as well . this would tend to drive up the stock price. On the other hand. but the point for our purposes is that existing shareholders do not necessarily find their financial interests hurt whenever a corporation issues new stock . if the existing shareholders issue more stock and spread their ownership over a bigger pool of people. For our purposes here.208
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original shareholders has been diluted .2 By expanding the pool of ownership in Acme itself.000 shares only represent (200.
note that the market value of Bill’s stock may very well increase because of the deal. if Bill Johnson owns a block of 200.000 shares . the new stock issuance brought in an additional $100 million which Acme officials intend to use to make the corporation more productive . even though his proportional share in Acme itself has fallen . he originally owned 10% of Acme . economists and other financial analysts have different theories and rules of thumb to explain the ideal balance between debt and equity for a given corporation .000 / 4 million) = 5% of Acme . and in that respect the market price of each share would be expected to fall . the issuance of new shares does not commit the corporation to a fixed stream of payments (the way the bonds would have) . unfortunately financial press accounts often give this impression when a corporation in the real world issues new stock . For example. but on the other hand they suffer proportional losses if Acme does poorly in the upcoming years . their stocks entitle them to a fractional share of ownership in Acme’s assets only after the other creditors have been satisfied . But after the new issuance of stock. Only time will tell if Acme’s decision is wise. It’s true that (loosely speaking) Acme’s assets now must be divided into 4 million pieces instead of 2 million.
2
. the new shareholders share in the “upside” if the expansion goes well and the corporation enjoys substantial earnings. In contrast. it is enough that you understand a new issuance of debt (versus equity) increases the possible returns to the existing shareholders. Because shareholders are residual claimants. and hence the market value of Bill’s 200. before sending a dividend to the shareholders . Bill’s original 200. out of their revenues in a given year. but it carries greater risk .

corporate stocks are a particular avenue for his saved funds . the distinction is blurry . absent a default by the issuer .)
3
even here. the market price of a stock can be very volatile.4 In the eyes of many. the greater the potential returns for its owners. the investor can choose to purchase shares of stock in one or more corporations . But so long as the investor holds a given bond to maturity. the higher a firm’s leverage. more aggressive investors are interested in companies carrying high debt loads but with a sound business plan . the speculator does not seek out sound companies to invest in. either because of periodic dividend payments—in which the corporation distributes some of its excess earnings to shareholders—and/or because the market price of his stock rises . His hope is that the market value of his investment will grow over time. Many people invest at least a portion of their savings in corporate stock.3 Although there is in fact no clear dividing line.
The Social Function of Stock Speculation
From the individual investor’s viewpoint. firms differ in the amount of leverage they take on . but rather because he expects the share price to rise in the near future . someone might think a particular stock is underpriced because the company has such strong “fundamentals” and is likely to
4
. In the financial world. corporate stock is riskier than bonds . his flow of cash payments is fixed. whereas the return on a bond is contractually fixed. people often distinguish between stock investors versus stock speculators . A speculator buys a particular stock not because of the long-run potential growth of the corporation. Rather than keep money under his mattress or lend it to a bank.Advanced Lesson 14: The Stock Market
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A firm’s leverage refers to the relative size of its debt compared to the equity held by the owners . Certain investors buy stock in (or lend money to) conservative companies with little leverage. but the greater potential it has to go bankrupt . but rather looks for underpriced stocks to turn a quick profit . stock
Of course. (Bond investors also face interest rate risk. whereas other. which is the risk that interest rates will change and affect the current market price of the bonds they hold . because it typically offers a higher rate of return than bonds . meaning the investor (lender) only must face the risk of the bond issuer defaulting .

such a person could be classified as a speculator if he bought the stock.
. but because he expected other investors to soon see things from his perspective.000 on red at the roulette wheel. Of course.) In anticipation of this appreciation. sam can then sell his shares and pocket the $50. not because he wanted to partake in a long stream of dividend payments. sell high . the motto of the speculator is to “buy low. In Advanced Lesson 13. if and when other investors begin to see things as the speculator . After all. but there is an essential difference: When someone bets $1.000 if he sold his holdings at the end of the week .” the astute speculator identifies stocks that are mispriced before others notice the problem. If his hunch is correct and the report causes the stock price to rise to $45. if sam had been wrong and Acme shares fell to $35. the bigger this gap or mismatch between resource and consumer goods prices must have been . his very action tends to
enjoy strong earnings in the future . Many observers liken stock speculation to pure gambling. and benefits accordingly.000 shares of Acme . sam buys 10. we learned that the successful entrepreneur buys resources at a low price and transforms them into finished goods and services that fetch a higher price . For example. the greater the profits an entrepreneur reaps. because these shares represent partial ownership claims on Acme’s future earnings . and bid up the price of the stock . this action doesn’t influence the movement of the wheel—at least not in an honest casino! However.210
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investing is a perfectly respectable and indeed crucial feature of a market economy. these changed expectations will lead investors to bid more right now for Acme stock.000 shares of Acme because he believes its price of $40 is too low.000 gain from his speculation . the entrepreneur thus serves a vital social role in channeling scarce resources into those activities where (loosely speaking) the most market value can be added . and that the price will rise to $45 by the end of the week when a new report comes out . whereas stock speculation is deemed unethical and harmful . suppose Acme’s stock is selling for $40 per share but sam the speculator believes this is far too low. (the report will have favorable news that will cause many investors to revise their expectations about the future earnings of Acme . the stock speculator is just a particular type of entrepreneur . when sam the speculator buys 10. he would be down $50. this popular condemnation of stock speculation fails to appreciate the genuine contribution of this activity .

the presence of speculators makes the stock market as a whole more orderly and safer for average investors. More fundamentally.000 because of his speculative move . speculators keep stock prices from straying too far from where they “ought” to be. which in turn possess scarce physical assets and produce goods and services for their customers . to summarize. sell them to collect the current market price of $40. For example.Advanced Lesson 14: The Stock Market
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push up the price of Acme stock . nonetheless their activities are socially useful for several reasons . After all. and in that sense reduce the day-to-day movements in stock prices . and then buy them back if and when the price falls to $38 . then their actions will tend to push down the price . and so (other things equal) the price of Acme stock will rise .000 shares. but he also has an additional $20. their actions pull up prices when they are too low. who don’t need to worry as much about a particular stock dropping 30% after a “surprise” announcement—the speculators will usually have sniffed out the story weeks in advance and already moved prices accordingly . the demand for Acme shares has suddenly increased while the supply of shares is the same. On the other hand. and they push down prices when they are too high . and then buy the shares back at a lower price and return them to the original owners . if speculators believe a certain stock is overpriced. their attempt to profit from their prediction causes the underpriced stock to rise in value . because (other things equal) his selling at $40 would tend to push down the price of Acme shares .5 In this case too. it’s important for stocks to be accurately priced because they represent something real—they are partial ownership claims on corporations. they can engage in a short sale in which they borrow shares of stock from existing owners. Although their motivation is presumably personal financial gain. Recall that the relatively high
even speculators who originally own no shares of Acme can profit from a perceived overvaluation .
5
. He can sell off 10. speculators—if they are successful—actually reduce the volatility of stock prices . successful stock speculators identify and correct mispriced stocks . After all. suppose an Acme shareholder believes his stock is overpriced at $40 . the speculator’s efforts to gain personal profit end up moving the stock price in the correct direction. He ends up with the same number of Acme shares in his possession. so we see that when speculators believe that a stock will rise in the future. First and most obvious.

Rather than holding a large share of the company (and having to vote on important decisions affecting software development and so forth) such investors would probably diversify their savings among the stock of many other corporations. to take a silly example: If for some reason Microsoft shares suddenly plummeted so that with a measly $1 an investor could purchase an entire block of 1 million shares.000 and an idea of “a better way to run Microsoft . of course. but the high share price ensures that the people making such decisions will take their responsibilities very seriously . recall what we learned in the previous section: One of the ways a corporation can raise new funds is to issue more stock . the market value of Microsoft is (as of this writing) hundreds of billions of dollars .000 .6 Finally. By improving the accuracy of stock prices.” In reality. thus the fate of hundreds of millions of PC users would be at the mercy of anyone with $9.e . a very valuable corporation needs to have a very high market price (i . speculators help allocate the flow of new savings into corporations. deferring to true experts in any particular one .
even very rich investors will likely hold a relatively small portion of Microsoft. so that those corporations with the best prospects will have higher stock prices and thus tend to receive more funds for expansion .212
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market price of gold acts as a signal telling entrepreneurs. “Only use me in very important projects where the customer is willing to pay much more for the use of gold . if they are not knowledgeable in the computer industry .. share price times the number of total shares) to ensure that it ends up in the hands of serious owners who will make good decisions affecting the fate of the corporation .
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. Its major shareholders may make critical mistakes when they assemble a Board of Directors and decide other issues.” In a similar fashion. then that would mean someone could purchase Microsoft itself if he were willing to plunk down about $9.

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Lesson Recap •••
• The stock market (located at physical exchanges but also on computer networks) brings together buyers and sellers of ownership shares of corporations. because their actions push up stocks that are underpriced and push down stocks that are overpriced. • Stock speculators try to “buy low. and who therefore are ultimately responsible for how these organizations conduct business. It owes a contractual amount of interest payments and the return of principal. These investors are entitled to their share of the corporation’s earnings. when a corporation issues equity. On the other hand. The stock market determines what group of people are the actual owners of corporations. regardless of the success of the corporation. which are tied to the success (or failure) of the corporation.
. sell high” (or “sell high. buy low”). it sells shares in order to raise funds from investors. Successful speculators fix “mispriced” stocks. • When a corporation issues debt. it sells bonds in order to borrow funds from lenders.

the broker will act on behalf of the client and execute his or her orders to buy and sell shares .
Incorporation: transforming a business into a corporation.
Raise capital: the process of obtaining funds for a growing business by
selling partial ownership of the business to outside investors . located on Wall street . the most famous example is the new York stock exchange.
Sole proprietorship: A business owned by a single person . someone who buys 5.000 total shares of stock in a corporation.214
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new Terms
Stock market: A special type of market in which buyers and sellers exchange shares of corporate stock .
Going public: Allowing the general public to buy shares of stock in a
corporation.000 shares owns 5% of the corporation itself .
. as opposed to restricting ownership to those specifically invited by the owners .
Stock brokerages: Companies that help individuals buy and sell stocks .
Corporate stock: Partial ownership claims to a corporation .
Stock exchanges: Particular locations or venues where stocks are traded . If there are 100. so that its
ownership is allotted by shares of stock .

Residual claimants: Refers to stockholders. Rolling over debt: Paying off an old set of bondholders by issuing new bonds .Advanced Lesson 14: The Stock Market
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Initial public offering (IPO): the auction of shares to the general public when a corporation first decides to go public . Leverage: enhancing the potential returns from an investment by using borrowed money . Refinancing (a mortgage): the situation that occurs when a homeowner gets a new mortgage from the bank (perhaps at a lower interest rate or with lower monthly payments) and uses it to pay off the current mortgage . Bankrupt: the situation that occurs when a business has liabilities greater than its assets . who are entitled to the earnings of a corporation only after the other creditors have first been paid . Issuing debt: Raising funds by selling bonds to lenders . Issuing stock / issuing equity: Raising funds by selling stock shares to investors .
. Callable bonds: Bonds that the issuer (borrower) has the right to pay off ahead of schedule . Dividend: A disbursement of a portion of a corporation’s net earnings to the stockholders .

or who sells an asset thinking its price will fall .
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Speculator: A person who buys an asset (such as a corporate stock) thinking its price will rise. the person eventually must buy back the asset to return it to the original owner . Interest rate risk: the risk bondholders face because rising interest rates will reduce the market value of their bonds . Short sale: A transaction in which a person borrows an asset (such as a share of stock) from an existing owner. in order to sell it at the current price .

will its stock be more likely to appeal to a conservative or an aggressive investor? 5. can we figure out how much of the corporation Jim owns? 2. If Jim owns 200 shares of a corporation. If a corporation is highly leveraged. What are the two basic options a corporation can take to raise new funds? 3. *How do successful speculators reduce the volatility of stock prices?
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sTudy QuesTions
1. Who gets first dibs on the earnings of a corporation—the bondholders or the stockholders? 4.

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Part III
SOCIALISM: THE COMMAND ECONOMY
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Yet ultimately.
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. and economic outcomes are determined through the combination of actions taken by all of the resource owners . socialist theorists have proposed different methods by which government officials would reach such decisions. In this lesson.Lesson 15
The Failures of Socialism—Theory
In this lesson you will learn:
• The definitions of socialism and a command economy. In contrast. we explained the basic structure and functioning of a pure market economy . perhaps taking into account the desires of workers and the preferences of consumers . in a pure command economy the government owns all the resources and makes all the decisions of what to produce with them . Depending on the writer. and give orders to factories and farmers . Remember that in a pure market economy. • The calculation problem of socialism. the ownership of resources is dispersed among private citizens. or what is also called a command-and-control economy . we will explain the idea of a pure command economy. • The incentive problem of socialism.
The Vision of Pure Socialism
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n Part II of this book. in a pure command economy it is the government that must assign jobs to workers.

there are serious flaws with their proposals .
there are some socialist thinkers who are also anarchists. You should be aware.222
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Although granting such awesome powers to government officials1 may sound frightening to many readers. so too did socialist reforms champion economic democracy in which important economic decisions would be decided by the people (as represented by government officials) rather than by a rich minority who owned most of the (private) property . using our knowledge of economics we will try to simply think through the idea of socialism and highlight some major problems that will occur any time it is implemented . the results ranged from bad to horrible. to keep things simple we will continue to assume in the text that we are dealing with government control. whereas a command economy supposedly organizes the structure of production in order to serve the interests of all of society . large property holders). however.e . Despite the good intentions of many socialist reformers. the historical appeal of a command economy is the possibility of avoiding the seemingly unjust outcomes that occur in a system based on private property . but much of the economic analysis would apply to the “anarcho-socialist” proposals as well . In the next lesson. Indeed the very terminology is emotionally laden: A market economy is called capitalism. Obviously this type of socialist does not advocate that the government seize control of all resources .. we will briefly examine the historical record to see what happened in practice when some countries actually tried to implement socialist reforms . whereas a command economy is called socialism . As we will see. Just as political revolutions swept away the monarchical and aristocratic power structures that had favored an elite minority. In other words. and will help to confirm the theoretical arguments we make below . such labels imply that a market economy exists to serve the interests of the small class of capitalists (i . that many self-described socialists would deny that their system entails state power over workers . meaning they propose the abolition of the state along with the abolition of private property .
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. we will explain the major theoretical problems with a society that abandons the institution of private property and tries to replace it with socialism . In the present lesson.

such as rewarding the comrades who work in the coal mines with more vacation days per year or with longer lunch breaks .” it’s likely that most people would eventually not work nearly as hard as they did under a capitalist framework . this takes away the most obvious method by which the socialist government can get “volunteers” for the distasteful jobs that must be performed . under pure socialism—at least as phrased in Marx’s famous slogan— what people get to consume should have no relation to what they produce as workers . Yet many observers would say that human nature itself implies that people won’t work nearly as hard in order to help society at large. most 8-year-olds don’t announce. “I want to be a janitor when I grow up. socialist theorists have proposed other types of compensatory schemes. and then the government distributes the goods (such as residential housing) to various recipients according to criteria that are considered just or fair (such as how large a particular family is) . “From each according to his abilities.
. which could cripple the performance of any socialized economy . wages can adjust to attract more workers to a particular occupation . If a government really tried to implement the Marxist slogan. to each according to his needs. who will pick up the trash and who will clean the public restrooms? In a market economy. It’s true.Lesson 15: The Failures of Socialism—Theory
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Socialism’s Incentive Problem
the most obvious problem with socialism is that it alters the incentives that both producers and consumers face.
Who Picks Up the Garbage?
the problem of coaxing workers to put in long hours is related to the problem of distasteful jobs . under a socialist system.” but the reason some people become janitors is that the job pays more than many other jobs requiring similar education and experience . but there will be far fewer goods to be distributed . then a socialist system might distribute its goods more “fairly” than a capitalist system according to a reformer’s criteria. If these critics are right. simply put. One of the key principles of a pure socialist system is the separation of production from consumption. meaning that workers use resources to first produce a pile of output. naturally. as they will when they get to keep the fruits of their efforts .

some of the more naïve reformers thought that a socialist government could retain the worker’s right to choose his or her occupation. Yet even if we allow for the use of punishment. a market economy might induce 100 men in a certain city to voluntarily agree to set their alarms every morning to collect trash for 8 straight hours. because they are paid enough money to afford a nice lifestyle . though the problem of trash collection could be solved in this way—by cutting hours—the socialist leaders now have 100 fewer workers for every other occupation compared to the capitalist system . a socialist government would still face the problem of a drop in overall output because of the lack
. in principle they could also tell each “unit” of labor what role he or she would play in the grand economy-wide production plan . but other thinkers were far more candid about the duties of workers in a socialist society . other members of the market economy strike a bargain.224
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this might help somewhat. If the amount of personal consumption is to be based on considerations other than a worker’s contribution to total output—in other words. For example. Just as the socialist leaders have the authority to decide what crops should be planted on each acre of farmland. and drive a boring car just like every other worker . the socialist system might need 200 men devoted to trash collection. this is just a particular manifestation of the broader problem—that under socialism. I’ll produce medical services / cook you a steak dinner / teach your kids algebra / etc . “If you will deal with my trash every week. In essence. who only work 4 hours a day. an obvious “solution” to the problems of shirking and the performance of undesirable jobs is that the government could simply force people to fulfill particular tasks . this type of voluntary bargain is not available if the socialist leaders truly wish to depart from the methods of capitalism and private property . but it still could lead to absurdities in the use of scarce labor power . Historically. if workers are to be rewarded in a way different from what would happen under capitalism—then the leaders must tinker with the other characteristics of jobs in order to get enough volunteers for each occupation .” to repeat. For example. rather than having 100 men pick up trash and earn enough money to buy a fancy car. it is likely that many or most workers would not put forth the same effort that they would under a capitalist system in which their lifestyles were directly tied to job performance . Of course. saying.

An equally important. capital goods. either . In a market economy. it would have to issue either more bonds or stock in order to finance the project . which the government planners must take as a starting point when they draw up a complex blueprint for the entire economy . incentive problem involves the allocation of “capital” to new “firms” in a socialist system . but it wouldn’t have occurred to them to demand. even so. they could have threatened to whip or imprison the young Gates if he didn’t process enough statistical reports per hour. under socialism. as it were.Lesson 15: The Failures of Socialism—Theory
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of cooperation from many of its workers . until finally the shareholders either explicitly or implicitly gave their approval . even if they were willing to use draconian penalties. the managers would in turn make the case to their superiors and so forth. in a market economy the scientists employed by an oil company might convince their managers that it would be well worth it to spend $2 billion developing an offshore platform in a certain location in the Gulf of Mexico (and with extra safety measures in light of the BP spill) . and there aren’t independent firms. and workers with various skills. If the company didn’t have enough spare cash. ultimately private capitalists would need
. the allure of large financial rewards causes the best and brightest to rise up from the crowd.) until he stepped forward and demonstrated it in the market economy . etc . For example. though far less obvious.
Allocating “Capital” to New “Firms”
everyone can immediately recognize the potential incentive problem under socialism when it comes to workers and shirking . there’s just a massive collection of natural resources.” this is because no one had any idea of the genius lying inside the young Bill Gates (and thomas edison. the socialist planners would face challenges similar to those solved by the financial markets under capitalism . Henry Ford. Yet whether the project were funded internally or with outside assistance. or else we’ll kill your family . We are putting the terms in quotation marks. “You’d better come up with some computer ideas that will revolutionize the world. socialist rulers wouldn’t have been able to identify the potential output of a Bill Gates when looking at him and his peers at 20 years old . and demonstrate their talents and ambition . because strictly speaking there is no financial capital in a purely socialist system.

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to put their own saved funds at risk in the hope that the project would bring enough new oil to market to justify the huge expenses . notice that the potential risks and rewards of the offshore project still exist under socialism; they are not mere artifacts of a market economy . the socialist planners would not be omniscient; they too would have to rely on the guidance of scientists and other experts to estimate how many barrels of oil a proposed new platform would make available for future economic planning . Yet we now see the crux of the problem: How do the socialist planners responsibly pick the “winning” projects out of the thousands of competing proposals? After all, there are all sorts of ways one might deliver more barrels of oil—or energy in other forms—into the hands of future planners, but the current planners obviously cannot “fund” all of them, because there aren’t enough resources to go around . When it comes to this problem of choosing which risky ventures to approve and which to veto, the different incentives between capitalism and socialism manifest themselves once more . to see why, suppose the government planners decided to naïvely fund those projects that promised the greatest return—whether measured in barrels of oil, minivans, gallons of milk, etc .—for a standardized contribution of current resources . this would simply give project managers the incentive to exaggerate the merits of their pet proposals . note that they wouldn’t even necessarily be lying—though some obviously would—but rather they would understandably cite the most favorable studies and would not ask their staffs to spend much time dwelling on possible pitfalls in their proposal . the result would lead to a squandering of society’s scarce resources, as they were mobilized according to a central plan relying on the forecasts of the most unscrupulous and/or reckless promoters . On the other hand, the government planners would also face the danger of establishing an incentive scheme that stifled creativity and risk taking . For example, the planners might follow a procedure whereby they took the advice of formally trained scientists and other objective experts on various things, but that if anyone ever turned out to be horribly wrong in one of his or her predictions, then the planners would never again allow this particular expert to influence the grand economic plan . such a rule would certainly get rid of the snake oil salesmen, but it would also render the legitimate advisors far too conservative . People with bold ideas would be

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afraid to challenge the consensus of their peers, especially if their scheme would likely fail but had a small chance of being extremely successful . Of course, the socialist planners could try to avoid both extremes by establishing incentives that both encouraged sensible risk-taking but weeded out the demonstrably incompetent . For example, the planners could take the total amount of resources they intended to devote to “new project development” and assign responsibility for a certain fraction of the resources to an individual expert, based on that expert’s overall track record . Any particular mistake would not disqualify an expert, so long as his or her successes had more than compensated for the failures . to motivate the experts to take risks when they believed there was a chance for great payoff, the planners could also stipulate that the standard of living of the experts would itself be proportional to their overall track record in handling society’s scarce resources . We hope that you have noticed what’s happening . In the effort to correct the flaws with various ways of implementing socialism, our hypothetical central planners are led step by step to reinvent…capitalism .2

One Giant Monopoly
thus far we have focused on the incentive problem the socialist government would face in motivating its citizens to participate in the desired fashion in the economic plan . But there are enormous incentive problems going the other way, too . specifically, the government officials would have little incentive to take the preferences of the citizens (both as workers and consumers) into account when drawing up the grand economic plan . It is extremely ironic that many socialist reformers warn of the dangers of capitalist “monopolies” in particular industries, when their recommendation would establish one giant monopolist—the government—in control of all industries .
the great Austrian economist Ludwig von Mises made this argument in his classic work Socialism, originally written in German in 1922 (Indianapolis: Liberty Fund, 1981, pp . 192–94) .
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even in nominally capitalist countries, we can nowadays see this principle in operation . For example, it is a common joke that the Department of Motor Vehicles (DMV) is not staffed by the friendliest of employees . In many cities the subway facilities are in various stages of disrepair . the condition of government-run hospitals for military veterans—let alone for committed psychiatric patients—can be downright scandalous . As a final example, notice that during the hot summer months, beer companies and air conditioner technicians welcome the huge volume of business with open arms, whereas government-regulated utilities scold their customers for using too much electricity or water . there is a simple explanation for this undeniable pattern: When government agencies (or favored organizations in the private sector) provide goods and services to the public, they can’t be fired . People have to go to the DMV to get their licenses renewed and so forth; they can’t take their license business elsewhere to a company with friendlier staff . the manager of a grocery store has an incentive to keep surly employees away from customers, but the manager of a branch of the DMV doesn’t face nearly the same motivation . If his superiors were really interested in customer satisfaction, they could establish a compensation scheme whereby each DMV branch manager in a particular city were paid a bonus proportional to how many residents decided to take their “business” to that manager’s particular branch . But this simply pushes the problem back one stage: Why would the branch manager’s superiors care about keeping motorists happy, with all of the other things they have to worry about? It’s not as if the city government will take in more revenues from people who decide to become drivers due to the friendly DMV employees .3 to be sure, the people in a socialist society could vote in new government officials if they lived in a democracy, and they could ultimately undertake a violent revolution no matter what the form of government . All government officials—whether in a limited state presiding over a largely market economy, or even in a totalitarian socialist state run by a dictator—want to keep the public happy, generally speaking . even so, the difference in incentives facing the people “in charge” between a pure market economy and a
even if this were to happen, the people in charge of compensating DMV branch managers wouldn’t themselves be able to pocket the extra revenues from issuing more licenses .
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pure command economy is colossal . the very worst a capitalist “tyrant” can do is fire you (if you’re an employee) or refuse to sell to you (if you’re a customer) . In contrast, if the government makes all hiring decisions in the entire economy, and controls all the grocery stores, it can intimidate critics quite effectively by shipping them off to work in siberia or starving them . And don’t expect the newspapers or other media to document the abuses— the government owns them, too .

Socialism’s Calculation Problem
In the historical debates over socialism, its opponents would raise the incentive problems described above (or in other forms) and the proponents would usually respond by arguing that people growing up in a socialist paradise would learn to work for the benefit of their neighbors . they claimed that a new “socialist Man” would emerge, who was not selfish as people under capitalism were . the central idea was that in their natural state humans were benevolent and altruistic, but that the institution of private property conditioned them to become greedy and callous . Perhaps if the workers didn’t need to worry about providing for their families—so the socialists argued—they would have no qualms about going to the factories every day in service to the common good . In this context, the opponents of socialism developed a much more fundamental critique .4 even if there were no problems of incentives—so that the workers happily performed whatever tasks they were assigned, and the socialist planners truly had nothing but the best of intentions for their citizens—socialism still would do a very poor job of using society’s resources efficiently . Because the socialist government would own all of the resources, there wouldn’t be any markets for them . In other words, people wouldn’t be trading money for tractors, plots of farmland, barrels of oil, and so forth . this means that under pure socialism, there would be no prices for natural resources, labor, and capital goods . Without prices for their inputs, the socialist planners would have no way of estimating the total monetary cost
Ludwig von Mises systematically laid out the calculation objection, which we are about to summarize in the text, in a 1920 article .
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of their projects . therefore they would have no idea whether a particular project were making good use of the resources it consumed, or if it would help the citizens more by shutting down that project and using the freed-up resources to produce more of something else . Remember that in a market economy, accountants can use market prices to determine if a particular operation is profitable, or if it is suffering a loss . this measure provides a signal showing whether other property owners (implicitly) agree with an entrepreneur’s decision to commit scarce resources to the operation . A profit indicates that customers were willing to pay more for the finished product than the entrepreneur needed to spend in order to acquire the inputs . In contrast, a loss indicates that customers were spending more on other types of goods, allowing those entrepreneurs to bid up the prices of the required inputs and “fining” the original entrepreneur if he continues with his business plan . to sum up, entrepreneurs in a market economy receive constant guidance and feedback from the profit and loss test, which is only possible when all of the various inputs have market prices . the planners in a socialist system would have no such guidance . engineers, chemists, and other experts could explain to them the technological possibilities for using their stockpile of inputs in order to produce various combinations of finished goods and services . Yet although the planners would know if a project were technologically feasible, they wouldn’t know if it were economical . Without being able to plug in market prices for each unit of input as well as each unit of finished output, the planners couldn’t reduce the total inputs and total outputs to a common denominator and see if the operation as a whole created or destroyed wealth . therefore, even if we set aside the tremendous incentive problems, the socialist planners would also face an insurmountable calculation problem . to grasp the nature of the calculation problem, you should spend a few moments reflecting on the fantastic complexity of a modern economy . On Day One of drawing up their grand economic plan, the socialist leaders would have at their disposal millions of workers with varying skills and endurance; deposits of oil, coal, diamonds, and other minerals; various factories, warehouses, research laboratories, and educational centers; billions of individual tractors, hand tools, and other pieces of equipment, in

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varying stages of obsolescence; and finally various infrastructures including power lines, telephone and data lines, highways, and bridges . Also remember that to make a coherent economic plan, the socialist leaders would need more than a simple tabulation of the various inputs at their disposal . they would also need to know the location of the units . For example, if the plan called for a certain mechanic on tuesday morning to replace the worn-out tires on a tractor trailer, it would need to be the case that the mechanic, new tires, and tractor trailer were all located in the same city by tuesday morning! Yet even if the planners could somehow process all of this information—and do it quickly enough to update the economic plan in real-time in response to changing conditions—they still wouldn’t be able to overcome the calculation problem . In consultation with experts, they could determine various combinations of different output goods that they could produce with all of the inputs at their disposal . Yet even if they wanted nothing but to make their citizens as happy as possible, exactly how would they decide what to do? socialist critics of the market economy point to certain “abuses” and think that a group of experts could improve on the decentralized outcomes of a capitalist system . It strikes these critics as outrageous, for example, that some people own 10 sports cars and a yacht, while other people go hungry . But this ethical intuition is not enough to design an alternate economic plan . We can concede that the socialist planners would not use society’s resources in order to produce huge inequities in the standard of living among the people . Fair enough . that still leaves the question, what combination of goods and services should each person get? even if the planners decide that citizens will have the same number of cars—perhaps adjusted for the number of family members of a certain age range, and the locations of jobs for people in the household—they would still need to decide how many total cars to produce, and how fancy to make them . After all, the citizens would like to drive very comfortable, sleek cars with air bags, air conditioning, and high-quality speakers . But to pour more resources into this area would leave fewer resources for other things that the citizens would also enjoy, such as more DVD players or bigger houses or more distribution centers (i .e ., what would be called “stores” in a market economy) .

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The Loaded Term “Planning” . . .
The paradox of “planning“ is that it cannot plan, because of the absence of economic calculation. What is called a planned economy is no economy at all. It is just a system of groping about in the dark. There is no question of a rational choice of means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action. – Ludwig von Mises, Human Action, p. 696

Solving the Calculation Problem?
naturally, the socialist planners could devise various means of soliciting feedback from the people in order to serve them better . One obvious innovation would be to let the individuals or families have some means of influencing the grand economic plan . It would be obviously wasteful to literally produce the same exact combination of goods and services for each person, since vegetarians wouldn’t be interested in beef tips, whereas nonsmokers wouldn’t want a ration of cigarettes . Yet to avoid the inequalities of a capitalist system, the planners would still want some way of ensuring that every individual or family had the same “amount” of consumption, however defined . For example they might assign each person or family a certain quota of voting points each month, which they would use to order different goods and services . Items such as television sets and suVs would subtract more points from a family’s quota than items such as a can of soda or loaf of bread, because it would obviously take “more” resources to produce the former items . (In other words, it wouldn’t be fair if one family voted to receive 10 television sets, while another family voted to receive 10 cans of tuna fish . Clearly the former family would be consuming more than the latter .) In order to pick the “correct” number of points for each type of good,

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the planners would rely on feedback from the managers running the distribution centers . If the shelves were clogged with tVs and the supplies of tuna fish were running low, the planners could reduce the number of points a family needed to deduct to order a tV, while bumping up the number of points it took to order a can of tuna . this would clear out the excess stockpile of tVs and prevent the supplies of tuna from running out . unfortunately this type of trick would only deal with excess or deficient supplies after they had been produced . Going forward, the planners would still need to tinker with their grand economic plan to decide whether to produce more or fewer tV sets (or cans of tuna) in the next period . From the feedback they received from the distribution managers, they would have an idea of how many total tVs would be ordered at various possible point totals assigned to a tV . But that still wouldn’t tell them whether the correct decision would be to (a) make more tVs next period and assign them a lower point score or (b) make fewer tVs next period and assign them a higher point score . to solve this question, the planners might try pushing the voting system up a stage . they might give points to the various factory managers, allowing them to order different amounts of workers, gasoline, electricity, and so forth . Just as families were allowed to use their votes to order different combinations of finished goods, the tV producers and tuna producers would use their votes to order different combinations of inputs . that would help ensure that the tV producer didn’t “hog” resources unfairly at the expense of the tuna producer . But this too wouldn’t totally solve the calculation problem, as the planners would soon realize . Although it might seem appropriate to force each individual to consume the same “amount” of goods by assigning everyone an equal amount of voting points, it would clearly be nonsensical to insist that each factory manager get the same amount of resources for his or her operation . In other words, if the planners each month awarded the same number of voting points to the tV producer as the tuna producer, they would be ensuring that society devoted as many resources to tV production as tuna production . But why in the world would we expect that to be the right thing to do, in order to use society’s scarce resources to make the citizens as happy as possible?

but also in the decision of how many units of each good to produce in future periods . . then in the next period the socialist planners could award five times as many voting points to the tV factory managers as they did to the tuna producers . proportional to the amount of points that the citizens earmarked for those goods at the distribution centers . .
. the way the socialist planners can solve the calculation problem is to make their system operate more and more like . By now you have probably realized where our discussion is heading . if the citizens used five times as many of their “consumption points” to order television sets as they did to order cans of tuna fish. In other words. this rule would allow the citizens to give feedback to the planners not only in terms of stockpiles of already-finished goods.234
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In order to come up with a coherent and objective way to solve this thorny complication. the planners could award points to each factory manager. capitalism .

” the total amount of output might shrink drastically. but the planners wouldn’t have enough feedback to guide them.
.” unorganized market economy. The socialists thought this system would be far more efficient and just than the “anarchic. because many people are not likely to work as hard when their individual rewards are not tied to personal performance. If the government were to implement the rule “from each according to his ability. Without market prices for the various resources and labor hours used in a production project.Lesson 15: The Failures of Socialism—Theory
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Lesson Recap •••
• The vision of pure socialism has the government owning all the resources and directing all the workers according to a unified. • Socialism suffers from an incentive problem. the socialist planners would have no idea if these resources were being used efficiently. to each according to his needs. • Socialism also suffers from a calculation problem. central plan for the economy. It might be possible to shift the resources to other projects in order to produce goods and services that the citizens would prefer.

Economic democracy: An analogy to politics often used by (democratic) socialists to justify socialism . Most people would not like an aristocratic system in which a few elites made all the political decisions. Anarchists: People who think there should be no government . one vote” system . according to a unified central plan . even if the planners were angels.
. they would have no idea whether they were using scarce resources in an efficient way to best serve the citizens .236
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new Terms
Command economy / command-and-control economy / socialism: An institutional arrangement in which the government owns all the major resources. and directs labor. the socialists argue that their program simply applies this logic to the economic arena. taking power away from the small group of wealthy capitalists and showering it on the masses . which points out that because socialist planners lack market prices for resources. Calculation problem: the objection Ludwig von Mises raised against socialism. Shirking: Deliberately working less than one’s potential . but would instead prefer a democratic “one person. they can’t determine if a particular project uses up more resources than it produces in goods and services .

What is the incentive problem inherent in the slogan. to each according to his needs”? 3. What do beer companies and electric utilities have to do with socialism? 5.Lesson 15: The Failures of Socialism—Theory
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sTudy QuesTions
1. *Why doesn’t a market economy suffer from the same calculation problem that plagues the socialist planners?
. “From each according to his ability. 2. Could a socialist government use punishment to overcome the problem of shirking among workers? 4. Explain the term command economy.

.

In this spirit. • The extreme poverty and deaths under many socialist regimes.
W
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. basic theory is not developed through a process of hypothesis which is then refuted or confirmed by empirical observation . we are not in the present lesson trying to “test” the analysis of socialism that we developed in Lesson 15 . Basic economic analysis is not a set of relationships discovered in a laboratory or after poring over reams of price data . In economics. On the contrary. strictly speaking. the lessons in this book give you a mental framework for interpreting price data and other historical evidence . we explained the difference between economics and the “hard” natural sciences such as physics and chemistry . then. the basic principles laid out in this book are largely logical exercises that simply coach you through particular trains of thought . Rather.
Economic Theory and History
ay back in Lesson 2. • The economic similarity between communism and fascism.Lesson 16
The Failures of Socialism—History
In this lesson you will learn:
• The relevance of historical evidence to economic theory.

On the contrary. what if these factors only meant that the switch from a pure capitalist system to a pure socialist one. the evidence is not conclusive.
. it would always be possible that our results.240
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regardless of the historical record of socialist regimes. were unimportant . For example. then we might wonder whether this book made an efficient use of resources by devoting an entire lesson to the topic of socialism. When it comes to the historical record and economic theory. the historical record is far more extensive than simple anecdotes of particular socialist regimes experiencing temporary calamity . it could be perfectly true that socialist rulers suffer from the calculation problem in determining the best uses for their country’s resources. but that they were counterbalanced by some virtues of socialism that we ignored in our discussion . the record of the 20th century is quite clear that regimes implementing socialism did not succeed in their promise to provide their people with a higher standard of living in a society free from unfair social privileges . still. though valid. it’s possible that the socialist policies would have ushered in unprecedented wealth. or even that we can now be sure that the arguments of Lesson 15 must “obviously” be correct . to be clear. the spread of officially socialist governments went hand in hand with some of the darkest episodes in human history . and it could also be true that workers in a socialist system do not have the same incentives to work as hard as they do under capitalism . As we will soon see. After all. the mere fact that a particular country experienced widespread starvation after implementing socialist policies doesn’t prove that socialism is a bad economic system . suppose the problems we noted with socialism were correct. except that the workers’ revolution occurred coincidentally at exactly the same time as a devastating earthquake or volcanic eruption . the economic arguments we discussed in the previous lesson would still be valid—assuming we didn’t make an outright mistake in our reasoning . the basic principles or laws of economics are couched in terms of tendencies. we must hold “other things equal” when discussing how a certain change will impact the economy . But as you will see. rather than the economics of leaving the toilet seat up . the historical record suggests that there is an enormous difference between socialist and capitalist countries . would make the average person 1% poorer? Or worse still. in the sense that it can trump economic theory. However. Remember.

however. say what you will about the inequalities and mercilessness of a pure market economy. though the institution of private property is symbolically retained . the 20th century experience with both “left” and “right” totalitarianism shows that this was no idle warning . the horrors of both soviet Russia and nazi Germany can be laid at the feet of socialism . extreme fascism is socialism. For although they differ in other important respects. whereas the fascists were more concerned with the strength of their individual nations (and the nazis in particular with the purity of racial bloodlines) . When it comes to evaluating the fruits of various ideologies.
. the Holocaust would not have been possible in a society where private property rights were sacrosanct .Lesson 16: The Failures of Socialism—History
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Communism versus Fascism
In typical political discussions. while on the extreme right are fascists such as Adolf Hitler and Benito Mussolini . Although there are various ways of categorizing political ideologies. who in turn would be a “leftist” compared to Hitler . According to this standard framework. On the extreme left are communists such as Joseph stalin and Mao tse-tung. this standard left/right spectrum makes little sense economically . and so fall in between these endpoints . the communists tended to be more concerned with international class struggle. Communism seeks to establish government ownership over the means of production through a revolution of the working class . the term Nazi itself stands for National Socialism . Barack Obama would be to the right of stalin but to the left of Ronald Reagan. the ideology of a regime or its ruler can be placed on a simple spectrum running from left to right . because the government lays down explicit rules governing how owners can use “their” property . they simultaneously have the power to do great harm . Fascism too seeks to establish absolute government control over the means of production. In practice. but rather the philosophy that would guide the socialist rulers in their steering of the economy to serve the collective good . communism and (extreme) fascism are both forms of socialism . Indeed. For example. Wise political thinkers have always warned that if rulers have the power to do great good. therefore. the term signifies that the difference between the communists and the nazis wasn’t over the sanctity of private property rights. other ideologies and leaders are much less extreme.

Capitalist countries also participated in great historical injustices such as the African slave trade. the people might implement safeguards. say. and imperialist exploitation of colonies . whereas the deaths we document below occurred among the socialist regime’s own populations . Another important difference in the criminal records of various regimes is the sheer quantitative disparity . those rulers might very well turn around and slaughter 500. now it is true. but also the Allied conventional bombing of German and Japanese cities which killed hundreds of thousands of civilians . including most famously the united states’s atomic bombing of Hiroshima and nagasaki. but socialism’s allowance for this possibility is surely an important thing for the group to ponder before giving their final answer . Many “leftist” thinkers would argue that
. naturally the proponent of a pure market economy would point out—quite correctly— that these actions were either (a) necessary measures of self-defense to protect property and lives. But if we are to acquit capitalism of the crimes committed under its banner. If a particular group of. they might be particularly interested to know that if history is any guide. extermination of indigenous peoples. the governments of capitalist countries participated in their share of mass killing as well. He could simply claim that in practice the soviet rulers didn’t implement true socialism .000 of them . 10 million citizens were deciding whether to embrace the institution of private property on the one hand. no Marxist academic at Harvard would have wished for the Russian people to suffer the purges of stalin . and/or (b) deviations from the principle of private property rights and thus not an indictment against capitalism as an institution . It’s true. and cite the experience of democratic socialist regimes in history that did not end up killing their own people. One important difference between the crimes of capitalist regimes versus socialist ones—important at least in terms of evaluating them as economic systems—is that the crimes of capitalist regimes largely concerned outside victims. then should we not give the same courtesy to socialism? After all. or to entrust their fate to a group of experts who would plan the economy on the other.242
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Socialism’s Body Count
In this final section we will very briefly review some of the general statistics concerning the sheer murderousness of various socialist regimes in the 20th century .

the material in this chapter is certainly not offered to excuse or minimize the crimes and atrocities committed by governments claiming to uphold the institutions of private property and free markets . Yet even if we agree with this comparison.
The Broad Numbers
You are no doubt familiar with the atrocities committed by the national socialists in Germany under the leadership of Adolf Hitler . as well as censoring all means of communication. to give you a quick idea of the contents. the record is still in favor of capitalism . ranging from a few years in eastern europe to several decades in the u . turned mass crime into a fullblown system of government .R . and do not realize that the totalitarian socialist regimes of the 20th century became internal killing machines on a scale that places them in a different category altogether . communist regimes were actually much worse .s . as Pinochet overthrew a democratically elected socialist and then implemented “shock therapy” economic reforms with advice from economists trained at the university of Chicago . it didn’t kill up to a quarter of the entire population in fewer than four years. and China. in order to consolidate their grip on power. Obviously one single person intentionally killed by a government is one victim too many . the terror faded.Lesson 16: The Failures of Socialism—History
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the Chilean dictator August Pinochet was the capitalist analog to Marxist dictators. we quote three excerpts from the editor’s Introduction:
Having gone beyond individual crimes and small-scale ad-hoc massacres.s .s . Yet many people have simply never heard the facts. the Communist regimes.
.R . and the regimes settled into a routine of administering repressive measures on a daily basis. As brutal and thuggish as Pinochet’s regime was. The Black Book of Communism is a respected collection of essays published by Harvard university Press . Many of the authors were formerly communist historians detailing the new knowledge of the activities of communist regimes after archives were made public with the fall of the u . You may not realize that in terms of numbers. as did the communist Pol Pot’s Khmer Rouge regime in Cambodia .s . After varying periods. and expelling dissidents . controlling borders.

the withholding of food.” nor the north Korea of Kim Il sung. none of the Communist regimes currently in vogue in the West is an exception to this rule—not the China of the “Great Helmsman. poisoning. 4)
. or both. .R . or through forced labor . 2–3) [W]e have delimited crimes against civilians as the essence of the phenomenon of terror . Periods described as times of “civil war” are more complex—it is not always easy to distinguish between events caused by fighting between rulers and rebels and events that can properly be described only as a massacre of the civilian population . .244
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However. nor even the Vietnam of “good old uncle Ho” or the Cuba of the flamboyant Fidel Castro. drowning. gassing. these crimes tend to fit a recognizable pattern even if the practices vary to some extent by regime . destruction of the population by starvation. the memory of the terror has continued to preserve the credibility. nonetheless. through manmade famine.7 million deaths Afghanistan: 1 .5 million deaths (p .000 deaths Africa: 1 . and thus the effectiveness. through which death can occur in transit . flanked by the hard-liner Che Guevara .s . the pattern includes execution by various means. . and. at one’s place of residence. deportation. in certain cases. (pp . based on unofficial estimates.s . the following rough approximation. gives some sense of the scale and gravity of these crimes: u . . of the threat of repression . hanging. such as firing squads. . battering. we have to start somewhere . or “car accidents”.: 20 million deaths China: 65 million deaths Vietnam: 1 million deaths north Korea: 2 million deaths Cambodia: 2 million deaths eastern europe: 1 million deaths Latin America: 150.

” Yet over time. And as many cynics noted during the Cold War era. this policy was a recipe for creating famine on a massive scale . the closest we can come to testing such a claim is to look at regions that were very similar in all other respects except for their institutional framework . which led to the deaths of hundreds of thousands. some apologists have argued that the crimes were the result of a particularly violent or oppressed people . one telling difference between east and West Berlin was that the guards on the soviet side
. the regime aimed to control the total available food supply and. two African countries that claimed to be Marxist-Leninist. language. the gap in the standard of living grew substantially. or in economics in particular . People cannot be completely controlled by the experimenter. to distribute food purely on the basis of “merits” and “demerits” earned by individuals . But if full-blown socialism were implemented in a civilized. One such example would be east versus West Berlin during the Cold War . were the only such countries to suffer these deadly famines . of people . things would be much different . since this was a wartime partition of the same city. religious views. And again in the 1980s. clearly the customs. it is no wonder that the Bolshevik revolutionaries took things too far once they gained power . 8)
Close to a Controlled Experiment
As we noted in the disclaimer at the beginning of this lesson. democratic society. and in some cases millions. (p . When it comes to the horrible legacy of communist regimes. ethiopa and Mozambique. and so forth were initially quite similar on both sides of the “Iron Curtain . the socialist could claim. with the capitalist society outpacing its communist mirror . only Communist countries experienced such famines.Lesson 16: The Failures of Socialism—History
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[O]ne particular feature of many Communist regimes [was] their systematic use of famine as a weapon . For example some have argued that after being oppressed by the czars for so long. Remember that in the period after 1918. so that it is impossible to repeat a particular experiment with the same initial conditions except for one minor tweak . with immense ingenuity. in truth there can be no controlled experiments in the social sciences in general.

(After World War II the soviet union was closely associated with communist north Korea. and now China fairly gleam with prosperity .
. an expanse of blackness nearly as large as england . When the sun drops low in the sky. north Korea’s creakily inefficient economy collapsed . even in parts of the showcase capital of Pyongyang. then. north Korea is simply a blank . Power stations rusted into ruin . It is baffling how a nation of 23 million people can appear as vacant as the oceans . north Korea faded to black in the early 1990s . south Korea. the neon of the fast-food chains appear as tiny white dots signifying people going about their business as twenty-first-century energy consumers . the headlights and streetlights. you’ll see a large splotch curiously lacking in light . An even starker illustration of the difference between extreme socialism and moderate capitalism is the case of Korea . while the American forces stayed in south Korea . whereas the border guards of capitalist countries had the job of keeping illegal immigrants out . Here is an excerpt from the opening chapter:
If you look at satellite photographs of the far east by night. Hungry people scaled utility poles to pilfer bits of copper wire to swap for food . entire villages vanish into the dusk . the lights went out . Japan.246
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of the Wall were there to keep people in their ostensible worker’s paradise. this area of darkness is the Democratic People’s Republic of Korea . which had propped up its old Communist ally with cheap fuel oil. With the collapse of the soviet union. even from hundreds of miles above. you can stroll down the middle of a main street at night without being able to see the buildings on either side . next to this mysterious black hole. the landscape fades to gray and the squat little houses are swallowed up by the night . in the middle of it all. based on interviews she conducted with defectors from north Korea .) Journalist Barbara Demick provides compelling anecdotal evidence in her book Nothing to Envy. the billboards.

But the deal fell apart after the Bush administration accused the north Koreans of reneging on their promises . you can do what you like without worrying about the prying eyes of parents. I met many north Koreans who told me how much they learned to love the darkness. they can’t read at night .M .s . or secret police . especially if you are a teenager dating somebody you can’t be seen with . Wrapped in a magic cloak of invisibility. and that compounds the indignity of spending their nights sitting in the dark . north Koreans complain bitterly about the darkness. north Koreans beyond middle age remember well when they had more electricity (and for that matter food) than their pro-American cousins in south Korea. the united states offered to help north Korea with its energy needs if it gave up its nuclear weapons program . When adults go to bed. they think of remote villages of Africa or southeast Asia where the civilizing hand of electricity has not yet reached . neighbors. which they still blame on the u . in winter. the darkness confers measures of privacy and freedom as hard to come by in north Korea as electricity . she was twelve years old when she met a young man three years older from a neighboring town .” a burly north Korean security guard once told me accusingly . You can see the evidence of what once was and what has been lost dangling overhead alongside any major north Korean road—the skeletal wires of the rusted electrical grid that once covered the entire country . sanctions . But north Korea is not an undeveloped country. but it was the story of one teenage girl and her boyfriend that impressed me most . it is a country that has fallen out of the developed world . sometimes as early as 7:00 P . “We have no culture without electricity.Lesson 16: The Failures of Socialism—History
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When outsiders stare into the void that is today’s north Korea. it is easy enough to slip out of the house . Her family
. they can’t watch television . But the dark has advantages of its own . Back in the 1990s.

this too was unheard-of among the average people of north Korea at the time . none of the restaurants or cinemas were operating because of the lack of power . pp . 3–5 . But the north Korean told Demick that three things jumped out at him from the photo. that too was an alien concept to north Koreans .1
When discussing her book on nPR. socialism has the power to devastate entire economies and literally starve (whether intentionally or accidentally) millions of people . by the time they started dating in earnest in the early 1990s. this was not the case in north Korea . First. the photo showed that average people in south Korea had cars . the photo showed that the striking worker—though clearly enraged with his fist clenched in the air— had a pen in his shirt pocket . It is crucial to know sound economics because civilization itself is at stake .248
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was low-ranking in the byzantine system of social controls in place in north Korea . to be seen in public together would damage the boy’s career prospects as well as her reputation as a virtuous young woman . which eventually made him risk his life by fleeing the country . there was nothing else to do anyway. 2009). so their dates consisted entirely of long walks in the dark . the theoretical concerns we raised in Lesson 15 are very real and very important . As the case of north Korea perhaps makes clearer than any other single comparison. and the point of course was to demonstrate the miserable condition of laborers in the exploitative capitalist society . third.
1
. the fact of the rally showed that the workers in south Korea were allowed to protest . second. Demick relayed the story of a defector who—ironically enough—decided he would leave north Korea after looking at his government’s propaganda against their southern neighbor . the photo showed striking south Korean workers who were at a protest.
Barbara Demick. Nothing to Envy: Ordinary Lives in North Korea (new York: spiegel & Grau.

Father and son were experts in absolutely everything. The country lurched from one harebrained scheme to another. be it geology or farming. 65
. Nothing to Envy: Ordinary Lives in North Korea (New York: Spiegel & Grau. offered ‘on-the-spot guidance’ to address the country’s woes. One day he would decree that the country should switch from rice to potatoes for its staple food. who was increasingly assuming his father’s duties.’ the Korean Central News Agency opined after Kim Jong-il visited a goat farm near Chongjin. p. ‘Kim Jong-il’s on-site instructions and his warm benevolence are bringing about a great advance in goat breeding and output of dairy products. Kim Il-sung or [his favored son] Kim Jong-il.” —Barbara Demick.Lesson 16: The Failures of Socialism—History
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The Fatal Conceit
“By the 1980s. the next he would decide that raising ostriches was the cure for North Korea’s food shortage. 2009).

Apologists for these regimes might attribute the deaths to famine. communist regimes literally killed tens of millions of their own people—these figures do not include casualties from foreign wars. Even when comparing regions that were initially quite similar—such as East vs. at the opposite of the “far right” elements of fascism. in which private property rights were subordinated to the will of the dictator. and North vs. West Berlin. South Korea—the standard of living diverged sharply after one half fell to communism. However. both Nazi Germany and Stalinist Russia were socialist regimes. • Standard political theory places communism on the “far left” of the spectrum. even though we may have developed an accurate economic law or principle using sound reasoning.
. in practice its influence might be minor compared to other factors that our reasoning has overlooked. This is why it is useful to supplement our theoretical critique of socialism by looking at real-world examples. but mass starvations did not occur in capitalist countries and there is ample evidence that these “famines” were conscious political tools to consolidate a regime’s power. Yet from the economic perspective offered in this book.250
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Lesson Recap •••
• Historical evidence can’t prove or disprove economic laws. • During the twentieth century.

though fascism (unlike communism) allows private individuals to officially retain ownership of the factories and other capital goods .
. Fascism: An economic and political ideology that also seeks extensive government regulation of all resources in the service of the collective good.Lesson 16: The Failures of Socialism—History
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new Terms
Communism: An economic and political ideology that seeks to gain government ownership of the means of production (in the name of the workers) through violent revolution .

Do governments that officially support capitalism ever kill innocent people? 4. What is wrong with the conventional “left / right” spectrum on which Stalin is the polar opposite of Hitler? 3.”
. which government massacred the largest number of civilians? 5. *Explain this subsection title: “Close to a Controlled Experiment.252
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sTudy QuesTions
1. *Does the historical record prove that socialism is a flawed economic system? 2. According to the text.

Part IV
INTERVENTIONISM: THE MIXED ECONOMY
.

.

which very
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. we explained the basic structure and functioning of a pure market economy . • How to analyze price controls using supply and demand graphs. which is an approach to economic policy that seeks to avoid the alleged flaws of pure capitalism and pure socialism . while at the same time moderating the “excesses” of pure capitalism through various corrective measures . and documented some of the horrors of socialist systems in practice .
In this final portion of the book. we will examine some of the most popular components of interventionism. • Examples and consequences of price ceilings and price floors. In Part III.
The Vision of Interventionism
I
n Part II of this book.Lesson 17
Price Controls
In this lesson you will learn:
• The definition of interventionism. the following lessons will demonstrate that government intervention into the market economy leads to unintended consequences. the goal of interventionist policies is to retain the obvious advantages of a free enterprise system. but on the other hand it doesn’t completely abolish private property . An interventionist government will not tolerate the outcomes of a purely free market. we surveyed the theoretical problems with pure socialism.

the idea is that a rising price hits the “ceiling” and is not legally allowed to go any higher . the following diagram illustrates:
. even according to the official goals of the interventions . the local or state government might impose price controls on items such as bottled water. it will cause a shortage of the good or service in question . You may be surprised to learn that many of the problems with modern society are either exacerbated or even caused by government intervention . in an effort to prevent merchants from “taking advantage of” the situation . electric generators. now if the government forces the price lower by imposing a price ceiling. Although the general public applaud such restrictions—if they weren’t popular. a classic example would be rent control. a price ceiling must be set below the market price . after a natural disaster strikes. temporary price ceilings may be imposed to prevent “gouging” of the public in times of distress . they wouldn’t be so prevalent—our knowledge of how markets work will show that price ceilings actually hurt the very people they are supposed to be helping . the actual market price will tend to be close to the market-clearing price. the following list isn’t exhaustive. For example.256
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often make the “cure” worse than the disease. in which the government imposes caps on rental rates for certain types of apartments . in which the government enforces a different price from the market-clearing equilibrium price . We break the discussion up into the treatment of price ceilings and price floors . but it mentions some of the most damaging consequences of price ceilings:
Immediate Shortages
If it is to have any impact. and gasoline. In specific situations. typically the official rationale for a general price ceiling is that it keeps important items affordable for the poor. the example of this lesson is price controls.
Price Ceilings
A price ceiling is a legal maximum the government sets on prices in the marketplace for a particular good or service. But under normal circumstances. which (we recall from Lesson 11) is the price at which the quantity supplied equals the quantity demanded .

000
12.1 there is now a shortage of 3. the number that owners put on the market for rent can definitely drop because of the new rent control law .000
10. At the lower price. At that price. Most obvious.000
Market for Apartment units
In the diagram above. the quantity of apartment units demanded rises to 12.000 apartment units. even the owners of dedicated apartment buildings might prefer to rent out only some of the units at the lower price. consumers want to rent a total of 10. the original price of $800 is the equilibrium price to rent an apartment in an urban neighborhood . homeowners who were willing to rent out a spare bedroom to a stranger at $800 per month. to a group of tenants who have passed more rigorous background credit checks and so forth .000 . claiming that “regular people can’t afford” to pay higher rents.Lesson 17: Price Controls
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P s
$800 $650
sHORtAGe
D Q
9. the market clears and everyone engages in as many transactions as he wants.000. but can’t find any available units . while the quantity supplied drops to 9. might keep it vacant (and available for their kids coming back on college breaks or for other out-oftown guests) if they can only charge $650 . and owners want to rent out 10. and threatening to heavily fine any landlord caught charging more than this amount . But then the government imposes a price ceiling at $650.
1
.
even though (in the short run) the physical number of apartment units doesn’t shrink.000 people in the neighborhood want to rent an apartment at the going price. subject to the high price . meaning that 3.000 apartment units .000 units.

If the local government passes an ordinance fining merchants who raise their prices on “necessities” in response to the emergency. People who get to the store a few hours later will walk away with no water or food at all . We know that they would prefer to pay $800 for an apartment rather than having none at all (since the quantity demanded would be 10. we must balance the gains to the 9. suppose a hurricane strikes a city.000 total at a price of $800).258
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shortages are quite serious because they make the good or service unavailable for the very people supposedly helped by the price control . even if we completely ignore the fate of the landlords—who are clearly worse off because of the rent control—and focus exclusively on helping tenants. either . but not an apartment of their own . the 9. knocking out the power and causing flooding that contaminates the drinking water .000 renters who have an extra $800 a month.000 renters (who save $150 a month) against the presumably much more traumatic loss to the 1. therefore. For such poor souls. For example. Left to their own devices.000 people who still have an apartment might be thankful that they are saving $150 per month on their rent (though perhaps not if they understand all of the additional points below) . It’s true. they would have fallen out of the market and not gotten an apartment in that scenario. However.2 At this first step in the analysis. the tradeoff is even more striking in other situations of price ceilings . what will happen is that the first few people to get to the store will clear out the shelves. loading up on bottled water and canned food at the pre-crisis prices .000 people in the community who would have had an apartment with market pricing but now have no apartment at all because of the price ceiling . but in a sense they are not really losing out (except for their headaches and time spent searching fruitlessly for an apartment) . If the price were allowed to rise to its market-clearing level. the market prices of bottled water and canned goods would have a tendency to skyrocket because of the sharp increase in demand versus the fixed supply . there are now 1.000 people who are frustrated because of the shortage.
2
. On the contrary. that won’t result in everyone (including the poor) getting access to the items . they would much rather
there are also an additional 2. and so they are clearly worse off because of the rent control . it is not clear that the price ceiling has actually made the group as a whole better off . the officially reasonable prices are small consolation .

which normally would cause a sharp rise in prices.
Lower Supply in the Long Run
In addition to the immediate drop in the short-run quantity supplied. as the population grows but investors do not view cheap apartment units as a very lucrative project . For a different example. than to have their family drink Coke for a week .Lesson 17: Price Controls
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have paid $5 each for 10 bottles of water. subsequent motorists will drive around town but see “no Gas” signs posted at all the stations . the problem may become worse over time. and possibly break down along the way . If the goal is to get as many people out of the path of the incoming hurricane as smoothly as possible. this unusually high price would cause the fleeing residents to only buy enough gasoline to get them onto the interstate where they would search for gas stations charging lower prices . However. People who live on the coast in the path of an oncoming hurricane will try to load the kids up and head inland . if they know the government will impose price ceilings in situations where they otherwise could have tripled their prices . they will have to get on the interstate. there will be an immediate shortage . say to $7 per gallon . Consequently the demand for gasoline in the coastal city will temporarily spike. as entrepreneurs and investors respond to the new realities and shift their efforts and resources to other lines that do not suffer from price controls . perhaps with very little gas in their tanks. However. Another illustration is gasoline .” then the first wave of motorists will fill up their tanks and empty out the gas stations . the high market price would have effectively rationed the city’s supplies of gasoline on hand (when the news of the impending hurricane hit) among everyone trying to leave town . For example. imposing price ceilings on gasoline is a horrible idea . if the city government threatens the gas station owners with fines or even jail for “price gouging. merchants who live in a town subject to flooding will not carry as large an inventory of bottled water and other goods. a price ceiling will also suppress the long-run supply. if rent control laws are applied in a major urban area. thus the expectation of price controls cripples one of the primary features of a market economy—
.

Non-price Rationing
One of the functions of the (undisturbed) market price is that it rations the available supply of a good among the competing demands for it . However.260
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entrepreneurs can foresee potential crises (water shortages) and know how to ameliorate them (stockpiling more bottles of water in normal times). or come from the same ethnic group. and may find it very difficult to find a place to live . they might insist on seeing several months’ worth of paycheck stubs. if someone wants more units of the good. For example. this of course strikes many observers as unfair. run a background check on the applicant. All that happens is that the rationing must occur through non-price mechanisms . he has to bid more dollars for it . whether from outright bias or because they subconsciously feel more comfortable letting someone move into the building when (say) he goes to the same church . ethnic minorities and recent immigrants—especially if they don’t speak the native tongue—will be at a huge disadvantage. When a price ceiling forces sellers
. under rent control landlords can be much pickier in which tenants they select for their available apartments . this outcome is the exact opposite of what most proponents of rent control desire . In essence. since it gives an obvious advantage to the wealthy . there are still more people who want to use the good. In such an environment. the government doesn’t eliminate the fact of scarcity. this actually might end up being more distasteful to the proponents of the price control. by placing a cap on the price. than there are units of the good to go around .
Drop in Quality
Another insidious effect of price ceilings is that they reduce the quality of the good or service being regulated . than the original price rationing . and require letters of reference from previous landlords . but they won’t act on their foresight because the government takes away the market’s usual rewards for such behavior . they might also prefer tenants who travel in the same social circles.

In essence. and they certainly are not going to get up in the middle of the night to deal with a tenant’s broken water heater .” Buyers caught paying less than the floor price face fines or other forms of punishment . But under rent control. For example. even if the tenant in unit 3-A has had enough and leaves. in which the government assures a guaranteed minimum price for certain agricultural products . a merchant who habitually treated his customers with rudeness. However.
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. In modern Western countries labor is the primary recipient of price floors . In the numerical example of rent control diagrammed above. the landlords are in a position to reduce the quality of their units so long as the tenants would still be willing to spend $650 in rent . without hurting their total sales revenues . in which the government does not allow the price of a good or service to fall below the “floor .
Price Floors
A price floor is a legal minimum. they might let the paint crack and peel on the building rather than apply a new coat regularly. the landlord knows there is a long line of potential tenants eager to move in . it wasn’t completely accurate to say (in our discussion following the supply and demand graph on page 257) that the 9. In a normal market. this is because they are not getting the “same” apartment unit in both situations . therefore. the term denoting shady and cruel landlords of low-income apartment units . price ceilings provide a margin in which the sellers can reduce the quality of the good or service. the public justification for price floors is that certain sellers deserve a higher price for their goods or services than what they would receive in a pure market economy . landlords are under far less competitive pressure to please their customers .3 In particular the government imposes a minimum wage making it
Farmers are also beneficiaries of price supports.000 tenants were better off because they had to pay $650 for an apartment unit that previously was $800 . the landlords might be slow to replace a burnt-out hallway light. would soon go out of business . rent control laws give rise to slumlords. and refused to live up to his contractual obligations. they have less incentive to make the good or service desirable .Lesson 17: Price Controls
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to receive a lower dollar amount per unit sold.

with the quantity supplied by unskilled workers . the following diagram illustrates the effects of a minimum wage law . then it will induce a surplus of unskilled labor . we will concentrate on it for the rest of this lesson . However in the text we will restrict the discussion to the purer intervention that comes directly from the government . Rather than punishing people who pay less than $10 per bushel of wheat. there will be a supply glut. which should make the proponents of the minimum wage reconsider whether they are really helping unskilled workers . As with price ceilings. Because this is the most popular and recognizable example of a price floor. this situation is more popularly known as unemployment .262
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illegal for an employer to pay a worker less than a certain amount per hour . If the government sets a floor above the market-clearing level.
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. Many economists view this as a form of government intervention. the consequences include:
Immediate Surplus (or Glut)
the market-clearing price (wage) for unskilled labor equates the quantity demanded by employers. Our analysis of a wage floor explicitly enforced by the government largely applies to the case where a union threatens violence or property destruction in order to raise the wages of its members above the market-clearing level . price floors have many unintended consequences. because governments typically do not punish unions for criminal intimidation the way they would punish other attempts (by employers during labor negotiations for example) to disturb voluntary transactions .
typically the government establishes this floor by using tax dollars to artificially boost the demand for the privileged items . the government steps in and buys up wheat (and stores it in silos) whenever the market price would otherwise fall below $10 .4 the analysis generally applies to other goods or services . meaning more workers are trying to find jobs at the going wage than employers want to hire . the analysis of this type of “price floor” is much different from the situation we are analyzing in the text .

the 80. they simply cannot get a job . In addition. At this wage. but there are 20. employers want to hire 100. the minimum wage law actually makes it more burdensome for an employer to give someone a job . It is crucial to realize that the minimum wage law does not compel an employer to hire a low-skilled applicant .Lesson 17: Price Controls
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P
uneMPLOYMent
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$8 $5
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80.000 unskilled people are willing to work at the going wage of $8 an hour.000 people who would have been happy to work at $5 an hour and yet now can’t get a job at all .
.000 people apply for these types of low-skill jobs . and 100. the equilibrium wage is $5 per hour .000 .000
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Market for Low-skill Labor services
In the diagram. When the government comes in and artificially raises the wage rate to $8 an hour. even at this stage.000 100. It’s true. It simply makes it illegal to hire the applicant for less than the minimum wage .000 workers. thus there is a shortage of 40.000 workers .000 other workers who are frustrated by the inability to find a job at $8 an hour. Far from penalizing the rejection of a job application. while the quantity demanded falls to 80. these 40. there are 20. but no matter how many applications they fill out. but they wouldn’t be working in any case since $5 an hour would be unacceptable to them . the quantity of workers seeking jobs rises to 120.000 120.000. it is not obvious that the minimum wage law is helping unskilled workers .000 who retain their jobs now make $3 more per hour.

) By artificially raising the bar of the minimum paycheck. an employer hires a worker because he expects the worker to bring in enough extra revenues to justify the paycheck . it would be smarter not to hire this person at all . nonetheless. they will respond immediately by cutting back on the number of employees . second. the government effectively makes it impossible for people with productivities below a certain level to get a job . he’d be losing money on the deal and would have no incentive to hire . then an $8 minimum wage would force an employer to lose $1 for every hour this person works . just as soon as contractual obligations allow .
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to say that the demand (not just the quantity demanded) falls in the long run means two things: First. If someone’s labor only produces. the number of workers who can find jobs will fall .6 For example. such as the loss of employee morale if the boss lets 10% of the staff go in response to a minimum wage hike . a
Or at least. they will desire to do so. even if the government eventually removed the minimum wage. If the employer wants to maximize his profits.
Lower Demand in the Long Run
If the government enacts a minimum wage law that takes employers by surprise. other things equal a minimum wage increase will reduce the profitmaximizing number of (low-skilled) employees for a given business . this raises his or her productivity on the margin.5 In the longer run (so long as they expect the minimum wage to remain in force) the employers will alter their businesses in ways that will reduce their demand for labor . the employers can install more equipment and better tools to allow each (retained) worker to perform more duties . say. Keep in mind that some unskilled workers simply do not produce $8 worth of extra output for every hour they are on the job . the equilibrium number of workers hired (at that point) would initially be lower than the original number of workers before the imposition of the minimum wage .264
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Ruling out cases of philanthropy or other non-commercial contexts. In practice there might be other constraints. (If the employer didn’t think the employee would do so. at the constant minimum wage. $7 of output per hour.
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A well-trained worker can load the soda dispenser with an empty cup and press a button.
Non-wage Competition
the “problem” that minimum wage laws seek to fix is that the demand for labor is not high enough so that every willing worker can find a job paying a generous wage . and pennies . thus rather than having to retain (say) 8 workers at $8 an hour with the old setup. as the register automatically shoots out the appropriate combination of quarters.Lesson 17: Price Controls
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given worker can produce more output per hour if his workplace has more machinery . Ironically this feature of minimum wage
note that at the original wage of $5 per hour. while using a specialized scoop to dump fries into a carton resting in a specially designed holder. Workers still need to compete with each other for every job opening. For example. nickels. thus saving $24 an hour . the restaurant owner can spend many thousands of dollars installing the latest equipment and floor design . Over the course of hundreds of shifts.
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. the worker might not even have to count it out. the government doesn’t alter this underlying reality . the renovation would only save the owner $15 an hour in reduced labor costs . By enacting a minimum wage. dimes. Part of the difference is the tremendous advances in automation in the last 60 years . Depending on the expense of renovation (properly accounting for interest and the depreciation of the new equipment).7 But after the renovations the restaurant is permanently less dependent on human beings to get the job done . If the customer needs change. it’s just that the minimum wage takes away one method of bargaining . as she listens to a drive-through order on her headset and then punches it onto a keyboard with buttons denoting each value meal . a modern fast food restaurant can be staffed by a handful of people and still serve hundreds of meals in a single shift. the minimum wage law could be the difference between designing a restaurant to be run by 8 employees versus 5 . the investment in redesigning the restaurant pays for itself . this investment allows him to achieve the same output but with only 5 workers. whereas the same feat would have required many more workers at a fast food restaurant in the 1950s .

Drop in Workplace Quality
By forcing employers to pay more per hour. But if the government requires that all new hires receive $8 an hour from Day One. a 20-year-old immigrant who doesn’t speak the native tongue and has no work experience could not possibly compete for a job opening in a factory against middle class suburban college students (home for the summer) who belong to the same gym as the factory owner’s family. stop providing free food in the lunch room. the workers who will fail on these criteria are largely the ones that the proponents of the minimum wage think they are helping .” be related to someone already in the company. Perhaps the bathrooms will be stocked with very cheap toilet paper and clinical-smelling hand soap .266
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laws hurts precisely those groups that are the most vulnerable and in need of employment . and set the thermostat higher in the summer and lower in the winter . and (in an office environment) might spend less money on office furniture . But if the immigrant is allowed to underbid the wage demands of the native college students. to get a job you “need to know someone. the employer might take a chance and hire the immigrant with broken english at. Minimum wage laws take away the ability of low-skilled workers to compete for jobs by lowering their wage demands . For example. which could allow him to move up the rungs of the wage ladder . he can get the job . For example.000 people
. and by ensuring a long line of willing workers ready to replace anyone who quits. minimum wage laws reduce the incentive for employers to make jobs attractive in other dimensions . employers will therefore fill the (smaller) pool of job openings according to other criteria . the immigrant can never get off the ground and establish a (legal) job history. suppose 3. Perversely. to see if he’s a hard worker and can be quickly trained . and so forth . $4 an hour. the employer might reduce break times. the minimum wage law takes away potential arrangements that would make employers and workers happier . the employer might be slower to replace overhead fluorescent bulbs. if the two applicants had to receive the same wage . say.

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make $8 an hour working at a very hot factory that is cooled only by fans . By arbitrarily setting a floor below the wage. thus the workers toil miserably away in their sweat-soaked clothes. the government might perversely cause the other job attributes to decline so that even those workers who keep their jobs end up being hurt—let alone those workers who can’t get a job at all . this sensible proposal will not occur. Although this final example is a bit contrived. the owner of the factory surveys the workers and they unanimously agree that they would much rather earn $7 .
. the owner of the factory reckons that with 1. the owner on the other hand would have to shell out thousands of dollars upfront to install the new unit. and the factory owner earns $50 less per hour of operations . if the employer would install central air conditioning .50 an hour. it’s true. the proposed pay cut would save her $500 per hour in labor costs . she does some research and believes she can install central air and pay the higher utility bills for about $450 an hour. it illustrates a major flaw with minimum wage laws: A job is attractive for many reasons. because it is illegal . all things considered .000 people working on any given shift. For her part. but they would rather have a smaller paycheck without dripping in sweat 8 hours a day . But if the minimum wage is set at $8 per hour. Clearly this sounds like a win-win proposal . the workers take a slight pay cut. but over time the lower wage payments would more than compensate for this initial outlay (and the higher utility bills) . the paycheck being just one .

• Supply and demand graphs effectively illustrate the shortages and surpluses caused by price ceilings and floors. Price floors lead to surpluses. nonprice rationing. Private individuals retain official ownership over most resources. lower long-run supply.
. but the government regulates their use of “their” property.268
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Lesson Recap •••
• Interventionism is a combination of socialism and capitalism. lower long-run demand. and a reduction in the non-monetary qualities of the buyer’s offer. and a reduction in quality. • Price ceilings lead to shortages. non-price competition.

Price floor: A type of price control on a particular good or service that sets a minimum level that a buyer must pay a seller . but instead by having the government directly buy the good or service whenever its market price would otherwise fall below the floor . (the effects of price supports are different from the effects of price floors .Lesson 17: Price Controls
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new Terms
Interventionism: the philosophy of the mixed economy. meaning that some workers cannot find jobs even though they are willing to work for the same pay and can perform the jobs just as well as the people who are employed .
. Price supports: Government policies that maintain a desired minimum price not by threatening buyers who pay too little. Price ceiling: A type of price control on a particular good or service that sets a maximum level on the amount a buyer can pay a seller . Price controls: Policies that punish people who exchange goods and services at prices different from the acceptable range prescribed by the government . Rent control: A price ceiling placed on apartment rents . in which the government heavily intervenes in the capitalist system to regulate how individuals can use their private property . Minimum wage: A price floor on payments to workers .) Unemployment: A surplus or glut on the labor market. Slumlord: the unflattering term applied to a landlord who doesn’t maintain the quality of the apartments and who is generally unscrupulous .

*How can minimum wage laws reduce the long-run demand (not just short-run quantity demanded) for labor? 5.270
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sTudy QuesTions
1. What is “mixed” in the term mixed economy? 2. How might price ceilings on gasoline impede the evacuation of a city in the path of an oncoming hurricane? 4. How can the quantity supplied of apartments fall. even in the short run? Isn’t there a fixed number of apartment units at any given time? 3. How can a minimum wage actually hurt even the workers who stay on the job?
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Lesson 18

Sales and Income Taxes

In this lesson you will learn:
• The general impact of government spending. • The three ways government typically pays for its purchases. • The specific impacts of sales and income taxes.

Government Spending
ne of the most profound ways that the government alters the economy, relative to the free-market outcome, is through its spending programs . In this lesson we will examine some of the ways in which these activities cause economic distortions, in light of our knowledge of how a pure market economy works . Remember to keep in mind that economic analysis by itself cannot decide for us whether a government policy is good or bad . However, objective economic analysis can show us that the typical justifications for interventionist policies are invalid . this is because the interventions themselves lead to a worse outcome using the very criteria given by those who support the interventions . Regardless of how the government obtains its funds, when the government spends the money it necessarily draws resources out of the private sector and devotes them to lines chosen by the political authorities . For example, if the government spends $100 million building a bridge, we know
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this is affecting the economy even if we don’t know where the $100 million came from . In order to physically construct a bridge, the government must hire workers and buy supplies such as concrete and steel . Once these scarce labor and materials are applied to the bridge construction, they are unavailable to individuals in the private sector . A particular worker is physically incapable of building a factory for a private corporation, during the hours when he is working on the government bridge contract . And obviously concrete and steel that are incorporated into the bridge, cannot be used in other buildings built by private entrepreneurs . If the political authorities simply declared that they were going to spend government funds in order to make themselves as happy as possible, economics would have nothing more to say . After all, when the owners of Disneyland decide to build a bridge connecting two areas of the theme park, they too are using up resources and making them unavailable to the rest of the economy . so why is there a problem when the government does the same thing? the crucial difference is that the owners of Disneyland are operating in the voluntary market economy and so are subject to the profit and loss test . If they spend $100 million not on personal consumption (such as fancy houses and fast cars) but in an effort to make Disneyland more enjoyable to their customers, they get objective feedback . their accountants can tell them soon enough whether they are getting more visitors (and hence more revenue) after the installation of a new ride or other investment projects .1 Remember it is the profit and loss test, relying on market prices, that guides entrepreneurs into careful stewardship of society’s scarce resources . In contrast, the government cannot rely on objective feedback from market prices, because the government operates (at least partially) outside of the market . Interventionism is admittedly a mixture of capitalism and socialism, and
strictly speaking, the accountants wouldn’t be able to attribute the profitability (or lack thereof) to a specific decision that the management made . For example, suppose that a gambling scandal ruined the good name of Mickey Mouse, just at the same time that Disneyland built a new ride . It’s possible that ticket revenue drops by 10% after the new ride opens, when it would have dropped 20% had Disneyland not opened the new ride (and partially offset the impact of the scandal involving Mickey) . even so, the accountants can objectively declare whether the business is earning a monetary profit or loss in absolute terms .
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it therefore (partially) suffers from the defects of socialism . to the extent that the government buys its resources from private owners—rather than simply passing mandates requiring workers to spend time building bridges for no pay, or confiscating concrete and steel for the government’s purposes— the government’s budget provides a limit to how many resources it siphons out of the private sector . (under pure socialism, all resources in the entire economy are subject to the political rulers’ directions .) However, because the government is not a business, it doesn’t raise its funds voluntarily from the “consumers” of its services . therefore, even though the political authorities in an interventionist economy understand the relative importance of the resources they are using up in their programs—because of the market prices attached to each unit they must purchase—they still don’t have any objective measure of how much their citizens benefit from these expenditures . Without such feedback, even if the authorities only want to help their people as much as possible, they are “flying blind” or at best, flying with only one eye . For example, suppose the government decides to build a public library in order to make books and internet access free to the community . Because the government only has a limited budget, it won’t do something ridiculously wasteful such as coating the library with gold, or stocking the shelves with extremely rare first editions of steinbeck and Hemingway novels . suppose the government tries to be conscientious,2 puts out bids to several reputable contractors, and has a modest library constructed for $400,000 . Yet even if outside auditors or investigative journalists could find nothing corrupt or shocking about the process, the question would still remain: Was it worth it to spend $400,000 on building this particular library, in this particular location? the crucial point is that we know one thing for certain: No entrepreneur thought that he could earn enough revenues from charging for book borrowing to make such an enterprise worthwhile . We know this,
We acknowledge that we are violating are own rule of tying action to the individual: In reality, “the government” doesn’t build a library . Instead, certain people make decisions, which sets in motion certain repercussions because of who those decisionmakers are and the obedience they command from other people in the community . But for the sake of brevity we will often say “the government” spends money, raises taxes, etc .
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because the library didn’t exist until the government used its own funds to build it! One way to think about government expenditures is that they necessarily call forth the creation of goods and services that people in the private sector did not deem worth producing .3 When the government spends money, it directs resources away from where private spending decisions would have steered them, and into projects that would not be profitable if private entrepreneurs had produced them relying on voluntary funding .4 thus the political authorities in an interventionist economy face one-half of the socialist calculation problem . even if we dismiss the above considerations on the grounds that “the preferences of rich people over resource usage are irrelevant,” the political authorities still have a problem in figuring out the best way to help the poor, disadvantaged, and so forth . For example, is it better to spend the $400,000 on a public library, or would it do “more good” if used to buy free flu shots for every child under the poverty line? In cases such as this, the government in essence is a giant distributor of charitable donations . even those citizens who welcome the concept should ask themselves: Why do we need to route our donations through the political process? Why not decentralize the decisions and allow each person to donate his or her funds to the various charities that seem most worthy? to be sure, the proponents of government intervention could offer (somewhat technical) replies to these questions .5 even so, at best the case
there is a subtlety to this claim: It very often happens that private individuals refrain from investments because they anticipate the government will step in . For example, if the government funds the construction of a new sports stadium, people will often say, “this wouldn’t have existed without help from the government .” It’s possible however that the reason private investors “needed” government help is that they knew they could shunt some of their expenses onto the shoulders of the taxpayers .
3

Keep in mind that private-sector organizations can rely on charitable contributions and not just revenues from commercial sales . A pure market economy is perfectly consistent with soup kitchens, homeless shelters, and so forth . the crucial difference is that in a pure market economy, the owners of these institutions would need to solicit voluntary donations rather than receiving funding from the government, which ultimately was not derived in a purely voluntary manner .
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For example, there are situations where private enterprise may be deemed inappropriate, such as the provision of military defense . there are also situations
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becomes one of finding the least-bad solution . Regardless of its possible benefits, government spending suffers from the calculation problem afflicting socialism . the system allows a select group of political authorities to override the input of private individuals in how (some of) their property should be used to steer resources into various projects . this is a very serious drawback for anyone who favors interventionism as a way to increase the “general welfare,” however defined .

Why Bureaucrats Have Such a Bad Reputation
A bureaucrat differs from a non-bureaucrat precisely because he is working in a field in which it is impossible to appraise the result of a man’s effort in terms of money. — Ludwig von Mises, Bureaucracy, p. 53

How Government Finances Its Spending
In addition to the economic distortion (relative to the pure market outcome) caused by government spending per se, additional distortions are introduced depending on the source of the government’s revenues . traditionally there are three main vehicles through which the government raises money: taxation, budget deficits, and inflation . When the government levies taxes, it decrees that individuals and corporations must pay money to
where we can imagine a majority of people agreeing to be “forced” to contribute money to a certain cause, so long as everyone else is similarly forced . For example most residents of a city probably wouldn’t view it as “theft” if the local government took $10 a year from everyone in order to maintain “free” garbage cans (placed on busy street corners) and street lights . Because of these types of considerations, many economists who are aware of the flaws with government spending would nonetheless maintain that there is a scope for some government purchases .

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the government according to certain rules . When the government runs a deficit, it borrows money from individuals, corporations, or other governmental institutions, by selling bonds . the government is legally obligated to pay back these loans with interest . Finally, when the government raises funds through inflation, it creates new money (“out of thin air”) and uses it to finance its purchases . Later in the book we will deal with government deficits and inflation . In the remainder of this lesson, we focus on two of the primary sources of tax revenues for the government: sales taxes and income taxes . Before proceeding, we should emphasize again that the distortions we discuss below are in addition to the distortions caused by transferring resources out of the hands of private entrepreneurs (subject to the profit and loss feedback mechanism) to be directed according to the political process . What we show below is that the government distorts the economy not just when it spends the money, but when it raises the funds in the first place through taxation . to see the difference, imagine an extreme case where the government imposes a 200% income tax, meaning that for every dollar you earn, you are legally required to send the IRs a check for $2! In that ridiculous scenario, it is clear that very few people would work, or at least very few people would work “on the books” and report their incomes to the government at tax time . Consequently, the government would collect very little revenue, and wouldn’t be able to spend much money pulling resources away from their most profitable uses . Yet surely it would be wrong to conclude that this hypothetical economy suffered from very little economic distortions due to government interventions . In this scenario, everyone would have quit his or her official job and would be forced to live off the land, or work in black market jobs that could be hidden from the authorities . the economy would be plunged into extreme privation because of the punitive tax code, even though it raised very little revenue and the government didn’t have a large budget . In summary, governments distort economies (relative to the pure market outcome) both when they spend money and when they collect funds . We now examine the specific distortions caused when the government collects money through sales taxes and income taxes .

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Sales Taxes
under a sales tax, the government mandates that a portion of the payment on certain transactions is owed to the government . For example, if there is a 5% sales tax on all restaurant meals, then diners who order $100 worth of food and drinks—according to the prices on the menu—must pay $100 to the restaurant, but then an additional $5 to the government . In practice, the restaurant collects the entire $105 from the diners at the end of the meal, and sets aside the $5 to be sent to the government at periodic intervals . sales taxes distort the economy because they force consumers to face incorrect prices . In our example of the restaurant meal, the diners must ultimately pay $105 for the particular combination of food and drinks that they enjoyed, when in reality the restaurant only needed to charge $100 in order to cover the expenses of the labor, raw meat, soda syrup, and other resources used to produce the meal . this distortion is obvious if we consider a case where the government imposes a large sales tax on some items—such as alcoholic drinks—while exempting other items from a sales tax altogether, such as fruits at the grocery store . this imbalance in sales tax rates causes the penalized goods to appear artificially expensive, giving consumers an incentive to purchase less of the penalized goods and more of the exempt goods . Of course many reformers would say, “that’s the whole point! We want to discourage people from drinking alcohol .” such a judgment relies on the reformers deciding that their own preferences should be given more say than the preferences of the consumers spending their money in the marketplace . economic science cannot say whether such paternalism is good or bad, but it simply notes that the consumers themselves would judge themselves worse off, at least narrowly conceived . the imposition of a high tax rate on liquor only takes away options from consumers . People who want to eat healthy always have the option of spending nothing on liquor, without the government artificially raising its price . Many practical economists advise governments to adopt uniform sales taxes with low marginal rates, in order to minimize these types of distortions . For example, rather than levying a sales tax of 10% on half the items in the marketplace, most economists would instead suggest that the government

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levy a 5% sales tax on all the items in the marketplace . this switch would bring in roughly the same amount of revenue to the government,6 and it would eliminate the arbitrary disadvantages placed on particular sectors of the economy . However, we should remember that in a pure market economy, prices mean something; they are indicators of real scarcity . Consequently, even if the government levies a “fair” single-rate sales tax applied uniformly to all goods and services, nonetheless it will distort the economy, because consumers will still have the incentive to not earn as much income in the first place . to see this, let’s take a ridiculous example where the government levies a uniform 100% sales tax on every item in the market . even though every sector is hit with the tax, it’s obviously not a “wash .” Consumers will end up buying fewer items in total, and will allow their monetary incomes to fall by working less (and enjoying more leisure) . Besides this obvious impact, there is also the subtle point that it is impossible to levy a truly uniform sales tax . For example, a 100% sales tax on chewing gum would make a $1 pack turn into a $2 pack, whereas a $50,000 sports car would turn into a $100,000 car . the sales of chewing gum would probably fall less than the sales of sports cars . up until now, we have been assuming that everyone in the society obeys the government’s tax laws . But in reality, as a sales tax rate becomes higher and applies to more and more items, more merchants and consumers will conduct their operations in the black market, meaning they will engage in
Actually the move to “flatten” the sales tax would probably bring in more total revenue, because more sales would occur at the lower rates, and because in the original scenario consumers would have shifted their purchases away from the 10%-taxed goods towards the 0%-taxed goods . therefore, in the new situation (when all goods are taxed uniformly at 5%), the actual number of sales on taxable items would probably more than double relative to the original scenario, which would more than offset the halving of the sales tax rate . (note that we are just discussing general tendencies; we could invent specific numerical examples where the “flat” 5% sales tax brought in less revenue than a particular 10% sales tax on half the items . For example, if the 10% tax rate originally applied to food and cigarettes, while the 0% tax rate originally applied to yachts and diamond earrings, then switching from that system to a flat 5% sales tax on everything would probably bring in less total tax revenue .)
6

g . the interest income earned from buying municipal bonds (issued by local governments) may be tax exempt. and distorts the allocation of capital funds . it causes distortions between these sectors .. income tax code. it’s
note that the 20% rate applies only to the $90. the higher rate doesn’t apply to the whole $100.”
7
. then it would be taxed—meaning the employee wouldn’t get to keep the entire boost in the paycheck . this is why (under normal circumstances) you can’t actually see your take-home pay drop after a pay raise that “puts you into a higher tax bracket . cartons of cigarettes) are much easier to trade on the black market than others (e . or sending in the legally required tax payments . For example. cars) . For example. if the employer took the money it otherwise would have spent on the health insurance premium for the employee.000 + $18.000 of income . suppose an income tax has two brackets with a rate of 10% for income up to $10. Another example of this type of distortion is related to the problems with health care delivery in the united states . and handed this money directly to the employee in the form of a higher paycheck. other things equal. whereas the interest income earned from corporate bonds will be taxed . under the current u .g .7 to the extent that the income tax exempts particular sources of income. it requires individuals and corporations to transfer some of their income in a particular period to the government .s .Lesson 18: Sales and Income Taxes
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voluntary transactions without reporting them to the government. and are often graduated meaning that different portions of someone’s (pre-tax) income are taxed at different rates .000) = $1.. this causes investors to lend more money to local governments and less to corporations. However.000 would thus owe the government (10% x $10.
Income Taxes
When the government levies an income tax. and 20% for income above $10. because some items (e .000. when employees receive health insurance as part of their job. this benefit doesn’t count as taxable income .000 . Income taxes are usually expressed as percentages. In other words.000 .000 in income falling in the second bracket’s range. A person with a pre-tax income of $100. this reaction is yet another distortion caused by sales taxes.000 = $19.000 + 20% x $90.

another major distortion from income tax codes comes from allowing particular expenses to be excluded (or deducted) from one’s taxable income . will only report to the IRs that he has $95. this is a major reason that health insurance is so intertwined with one’s job. the appropriate bracket tax rates will then be applied to this lower amount. At the same time. but it clearly causes large distortions between individual sectors. the distortion on this decision is not as severe as it may first seem . monetary income) is taxed more heavily . College students may prolong their educations. and to use their money in other investments rather than paying back the bank as quickly as they otherwise would have . homeowners can deduct the interest that they pay on their house mortgages from their federal income tax assessment . In the case of mortgage interest deduction. so someone with a pre-tax income of $100. so although people often assume that the mortgage deduction gives a huge bias toward homeownership versus renting. the distortion gives people an artificial incentive to prolong the length of their mortgage. In addition to exempting certain sources of income.000 but who pays $5. such a “loophole” in the income tax code arguably brings the economy closer to the market outcome overall (by limiting the applicability of the distortionary income tax). Competition among entrepreneurs in the housing rental market would tend to lower rents to tenants to reflect this feature of the tax code . especially if marginal income tax rates are high .000 in interest on the loan that he got from the bank to buy his house. If an entrepreneur buys a house and then rents it to tenants.. home prices are probably higher than they otherwise would be. and older workers may retire earlier . than for the employee to buy it him or herself . any interest on borrowed money is a business expense and hence tax deductible too .000 in income . people will work less if the reward for working (i . not to the true $100. For example. the total number
People often say the mortgage interest deduction gives an incentive to buy a home rather than to rent. In the economy as a whole. whereas people typically use their paychecks to go buy their own auto and fire insurance .280
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much cheaper (depending on the relevant income tax rate) for the employer to buy health insurance for the employee.000 in taxable income .
8
. Most obvious.e . if homeowners weren’t able to deduct their mortgage interest payments .8 the biggest of all distortions from the income tax code relates to the decision of how much income to earn in the first place . but prices adjust to eliminate much of this impact .

” For example.000. the downside is that the man would have to go through the hassle of moving.000 surely aren’t going to stop working because of the new tax! Yet this analysis ignores the fact that the monetary paycheck is just one component of a job’s overall appeal to a worker . but he will have to write the government a check for $12. since people who make over $80. Because some forms of income are easier to hide than others. Before the income tax. compared to his $80.000 .000 . and the longer commute . now if the man takes the job. However. Now the man must decide whether an additional $48. thus his after-tax income will only be $128. won’t have a noticeable impact on economic activity. the man would have to decide whether the extra $60.000 per year . a high income tax distorts their decisions about which jobs to
. since “people still have to work .000—not $60. the advantage of the new York City position has fallen significantly . He has applied for a job in new York City at a much larger firm where the salary is $140. this will occur both because people will truly work less (and engage in more leisure). he would have to pay much higher prices for housing or apartment rental. so long as it is modest.000 per year . but also because they will work “under the table” or “off the books” and not report their earnings to the government . but because it needs more revenue it creates a new tax bracket of 20% on all incomes above $80. relative to the pure market outcome . it is clear that in an economy with millions of workers. the job at the large firm would be far more stressful.000—per year compensates for the hassle of moving. his pretax salary will still jump to $140. making $80. we discuss an effect of the income tax code that many analysts overlook . because of the change in incentives .000. suppose someone is the top accountant working for a reputable firm in a sleepy town in the Midwest. Finally. more expensive housing. After the new income tax goes into effect. suppose the government originally has no income tax at all. Many observers would think that this would have little effect on the economy.000 in salary per year compensated for these drawbacks of the big city job . the higher stress. even if this particular man decides to move anyway. and the man would spend an extra two hours commuting each day .Lesson 18: Sales and Income Taxes
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of hours worked—particularly “doubletime” hours during holidays—will fall.000 salary at his current job (which falls just below the tax line) . some people argue that a tax hike. this encouragement of black market activity will distort the economy too.

In brief. Economics in One Lesson. eight or nine months of the entire year for the government. the capital available for risk-taking itself shrinks enormously.282
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accept . It is being taxed away before it can be accumulated. they decide that it is foolish to take risks with their capital. thus the income tax—especially as its top rate grows higher and higher—interferes with the market economy’s ability to attract workers into the appropriate channels through higher wages and salaries . and only six. capital to provide new private jobs is first prevented from coming into existence. but can keep only a fraction of it when they win [because of taxes]. People begin to ask themselves why they should work six. four or three months for themselves and their families.” —Henry Hazlitt. the “signal” sent by entrepreneurs bidding more for labor encounters interference from the tax code . 60 or 70 percent. and the part that does come into existence is then discouraged from starting new enterprises. The government spenders create the very problem of unemployment that they profess to solve. In addition.
Taxes Discourage Production
“There is a [discouraging] effect when personal incomes are taxed 50. 38
. p. If they lose the whole dollar when they lose.

and artificially encourages people to choose jobs that feature non-monetary advantages. • All taxes distort the economy. if the rates are not applied uniformly. and inflation. Even a uniform sales tax reduces the rewards from working. Sales taxes favor some goods over others. and into projects chosen by the political process.
.Lesson 18: Sales and Income Taxes
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Lesson Recap •••
• No matter how it is financed. borrowing. which artificially encourages people to opt for more leisure. An income tax penalizes work even more directly. government spending always diverts physical resources away from projects determined in the private sector. • Government typically pays for its purchases through taxation. relative to the free-market outcome.

Black market: the system of illegal transactions that violate government regulations . Income Tax Brackets: the thresholds of income that are taxed at various rates . the lowest tax bracket might include incomes ranging from $0 to $10. which is taxed at 3%. Sales tax: A tax that applies to goods and services as they are sold to the customer . For example. the deficit is the amount the government must borrow to pay its bills in a given period . Inflation: the creation of more money. Budget deficits: the excess of government spending over tax receipts . Graduated income tax: An income tax that applies higher rates to higher levels of income .000. which drives up prices .
. Paternalism: Overriding the desires of someone else because he or she is not considered competent to make the right decision . Income tax: A tax that applies to the earnings of an individual or a corporation . Income taxes are usually applied as percentages of the pre-tax dollar income .284
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new Terms
Taxation: the process in which the government takes ownership of portions of income or other assets from private individuals . sales taxes are usually applied as percentages of the pre-tax dollar amount .

taxable income is the original income after all deductions and other adjustments have been made .Lesson 18: Sales and Income Taxes
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while the next bracket might include incomes ranging from $10.
Tax Deduction: A provision in the tax code that allows a particular expense (such as medical expenses or the purchase price of a new solar panel) to be subtracted from an individual’s taxable income .
.001 to $20.000.” which allows an individual to buy more with his income . which is taxed at 5% . Taxable income: the amount of income actually subject to the official tax rates for each bracket . this means that tax-deductible items are paid for with “pretax dollars.

do we know that the tax burden is light? 5.286
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sTudy QuesTions
1. As long as people continue working. If the government raises a modest amount of money through taxation. does the income tax have little effect on the economy?
. How do we know that government spending diverts resources from the private sector? Does it matter how the government obtained its funds? 3. do we know that the private sector wouldn’t have built a library instead? 4. **If the government builds a library. *Does economics conclude that government spending is bad? 2.

In other words.1 When
Of course. a trade surplus (exporting more than importing) is good for a country’s economy. • The general case for free trade. If mercantilism were correct. But it is difficult to convey the essence of mercantilism without speaking of various countries as collective units regarding trade . while a trade deficit (importing more than exporting) is bad . because one or more countries can run a trade surplus only if other countries run trade deficits . countries per se don’t import or export goods.
1
M
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. According to mercantilism. countries could succeed only by implementing beggar-thy-neighbor policies. people within a country do . it’s not possible for every country to sell more goods to foreigners than it buys from them .
Mercantilism
ercantilism is an economic philosophy or doctrine which holds that a country grows rich by encouraging exports (goods and services sold to foreigners) and discouraging imports (goods and services bought from foreigners) . • How tariffs and quotas make countries poorer.Lesson 19
Tariffs and Quotas
In this lesson you will learn:
• The definition of mercantilism.

it makes perfect sense that the path to national riches is to accumulate increasing amounts of money. they view other countries as potential threats to their own nation’s interests .
For example. by consistently having more exports than imports. but they nonetheless support similar protectionist policies that favor (certain) domestic industries over their foreign competitors . Mercantilism was the dominant philosophy among the major world powers from the 16th through the 18th centuries . it seemed intuitive that running trade surpluses made a country richer . in which governments substantially rolled back their policies that had previously hindered imports and encouraged exports . (We will review some of the problems with mercantilism in the following sections . the British classical economists. During that period. then (if these were the only transactions) there would be a net flow of 20 ounces of gold out of Britain and into France . while it only imported 80 gold ounces’ worth of books from Great Britain.2 On the surface. a country’s stockpile of gold and silver would increase. large barriers still exist to the movement of goods around the globe . Political leaders do not openly advocate mercantilism by name. the world enjoyed a period of relatively free trade. especially when the money consists of physical gold and silver . destroyed the intellectual justification for mercantilist policies with their writings . notably David Hume and Adam smith. because “more” or “fewer” exports and imports were measured in terms of gold or silver values . Despite signing trade agreements to ostensibly capture the benefits of trade. In such a mindset.288
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government officials are motivated by mercantilist ideas. After all. when countries used gold and silver as the basis of their trading.) You may be surprised to learn that the major powers actually acted on this newfound wisdom . meaning that the gains of one country must come from losses imposed on other countries . During the 19th century. the rhetorical justification for trade restrictions today rests on “saving jobs” in the protected domestic industries (rather than the accumulation of physical wealth) . As you may realize. today governments do not support genuinely free trade .
2
. if France exported 100 gold ounces’ worth of wine to Great Britain. Because countries no longer use gold and silver as the common money. international trade is a zero-sum game.

compared to the amount of money that Japanese individuals spent buying goods from sellers who lived in the u .s . For example. and to understand why trade deficits (which is itself a loaded term!) per se are not a problem . Over the years. there is nothing significant about the political boundary separating “foreign” goods from “domestic” goods . faulty arguments) is to view “the united states” importing goods from “Japan .—because of the specific monetary policies or relatively weak labor laws in China . and in the remaining sections of this lesson we’ll explore the specific problems with two types of trade restrictions. we will not address such particular justifications for trade restrictions .s .s . car repair. the primary confusion underlying protectionist fallacies (i . collectively spent more money buying goods from sellers who were located in Japan.s .” In reality. economically speaking. someone might worry about trade deficits with China—whereas not lose a moment’s sleep over interstate trade deficits within the borders of the u . namely tariffs and import quotas . clothes.” all it means is that individuals in the u .. Just as an individual American trades with other Americans to obtain his food. there is nothing “uneconomical” about the united states in the aggregate trading with Japan . and began building a strong case for free trade .s . When we say “the u . It is true. economic thinkers have generalized these arguments and have also devised simpler. In this book. In this section we’ll review the basic rationale behind free trade.Lesson 19: Tariffs and Quotas
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The General Case for Free Trade
the British classical economists—most famously Adam smith in his 1776 Wealth of Nations—demolished the ideas of mercantilism. and medical services. We are here only trying to get you to see the general logic behind the case for free trade.
. it is individuals in the United States who buy goods from individual sellers in Japan. any more than it would be a “problem” if texans bought more from Floridians than vice versa . there are arguments for protectionist trade barriers that have varying degrees of sophistication . more intuitive ways of explaining the advantages of free trade among nations . Yet we don’t ever hear of texans wringing their hands over a “trade deficit” with Florida . In fact. runs a trade deficit with Japan.e . there is nothing intrinsically dangerous or unsustainable about this situation. imports” is just the adding up of all these individual purchases . talk of “u .

new York City and London are major financial hubs. the people in each country (on average) are all enriched by the option of trading with people from other nations . total world output (and hence average output per person) is greatest when different regions specialize in their comparative advantages (oil. Because of the tremendous differences among regions along natural.e . such as barrels of crude oil or bushels of wheat . Rather than having to produce everything domestically (i . attracting some of the largest financial institutions . Given those realities. but also things like average rainfall and sunshine—different regions of the world have the comparative advantage in producing different goods. Because of their different endowments of natural resources—which can include deposits of oil or diamonds.
.. wheat. which in turn export their own excess goods . etc . the world as a whole is always in a trade balance. there are regional differences that arise from less obvious sources as well. for various historical reasons. oranges.290
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Recall from Lesson 8 the benefits of specialization and the concept of comparative advantage. cars. the same logic applies to nations . By focusing on his or her (relative) strengths. the excess is then exported to other regions. Although an individual country can run a trade deficit with another individual country. it is only natural (and efficient) that a large portion of the world’s financial transactions flow through these centers—just as it is only natural (and efficient) for saudi Arabia to sell oil to the rest of the world . within the geographical borders of the country). historical. For example. as they apply among individuals in a pure market economy . and trade their surplus production with others who have specialized in something else . each person in the community can enjoy more goods and services through the benefits of voluntary trade . would be as nonsensical as a man refusing to go to a dentist in order to “create work” for his wife so that she has to be the one to clean his teeth and look for cavities . besides natural resources .) and produce far more of these goods than their own residents want to purchase . the case for free trade among nations is simply an application of these general principles . computer chips. to restrict the imports of cars from Japan in order to “create jobs” for American workers in Detroit. In Lesson 8 we explored the commonsense insight that individuals can enjoy a much higher standard of living if they specialize in one or a few activities. individual deficits and surpluses necessarily add up to zero . and cultural dimensions.

” and helps balance out the net flow of dollars to Japan resulting from the trade deficit in goods and services . if a Japanese investor buys a corporate bond issued by IBM. these deficits and surpluses need not cancel out. the government) says they can no longer trade with people outside of the house . and so it’s not as crippling when their “father” (i . It’s true.s .
4
.4 this would happen for the same reason that the people living in a particular house would be reduced to extreme poverty if the eccentric father suddenly announced that they were no longer allowed to spend money buying things from anyone living outside of the household . the people who compete with the imports that are now being penalized . (note that financial assets—such as stocks and bonds—do not form part of a country’s exports . not of kind . imposing a trade barrier can make some people in a country better off—namely. our hypothetical father has prevented his children from trading with almost the entire population of the earth . the united states. Looked at the other way.e . and then further imagine that an individual country decided to “protect” its domestic industries and “save jobs” by preventing foreign goods from crossing its borders.3 If we imagine an initial situation of worldwide free trade. the possible gains to the protected producers are more than offset by the losses to everyone else in the country . its residents would become much poorer (on average) . restrictions on goods coming into the country would not be nearly as devastating as a father’s restrictions on goods coming into a household . runs a net trade deficit with the-rest-of-the-world .
If you are an advanced reader.)
3
We added the qualifier “(on average)” because technically.Lesson 19: Tariffs and Quotas
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All the countries in the world (collectively) always buy exactly as many goods and services as all the countries in the world (collectively) sell . In a sense. However. this purchase “returns dollars to the u . sometimes people do not see the connection between (a) trade among countries and (b) trade among individuals living within the same country . For example. In contrast. But the difference is merely one of degree. for any particular country . the people living in a country are in a gigantic household. for example. we should make the technical point that a given country (such as the united states) can have a trade deficit with one country (such as China) while simultaneously running a trade surplus with another country (such as Australia) . this is possible because people outside the united states can invest in American assets .. But as we’ll see in the next section in the text.

a particular government can make its own people richer
to be clear. In the text we are dealing with the very popular—but misguided—belief that trade barriers make a country richer by stimulating the domestic economy . In other words.s . but rather a military claim . and specialization and comparative advantage. If someone argues that. we are here focusing on general economic arguments for and against free trade . producers of ballistic missiles shouldn’t be allowed to trade with people living in north Korea. For example. then you can understand why it would be incredibly beneficial if the u .s . this is why extreme trade restrictions imposed on the country would not be nearly as destructive as those imposed on a single household within the united states . borders . he would only be preventing Americans from trading with people who lived outside of the u . say.
5
We are calling it the economic case for free trade to distinguish it from other types of arguments . but only if other countries follow suit and allow the first country’s exports into their own markets . the case for free trade does not say.s . president sealed off the border and outlawed imports. It would of course be better still if foreign governments scrapped their own restrictions so that the foreign consumers had more options to import goods from the original country . still. could still develop among the hundreds of millions of people living inside the u . But regardless of what foreign governments do with their own trade policies. removing those obstacles—giving its citizens more opportunities for beneficial trading—makes them richer (per capita) . the gains from mutual exchange.s . therefore. government allowed its citizens to engage in unfettered trade with foreigners . it would still be the correct policy because the government has no right to restrict how people use their private property . if you can see how it would be incredibly beneficial if the eccentric father allowed his children to trade with other Americans.292
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if the u . that is not a specifically economic argument. as the discussion above should have made clear. “A country benefits from reducing its trade barriers. u .” no. someone versed in natural law theory might claim that even if free trade made countries poorer. when a government erects trade barriers it takes away options of exchange from its own people . we should emphasize an important point: The economic case6 for free trade is unilateral .5 Before moving on to deal with the specific protectionist measures (namely tariffs and quotas).s .
6
.

Americans would become much richer (per capita). let’s examine the typical ways that governments restrict the flow of goods across borders . reducing its trade barriers against Chinese (and other) imports . because they would now have more trading opportunities . Although the government might levy a tariff for the simple purpose of raising more revenue. but it makes Americans better off too .s . But that is completely irrelevant to the case for the u . meaning that on average people in China would benefit from the move . but if this occurred it would simply be gravy for Americans . We know that if China pursued a free trade policy. because lowering American trade barriers is not really a “favor” at all .Lesson 19: Tariffs and Quotas
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immediately by removing all trade barriers and enacting a unilateral free trade policy . If the u . enacted its own free trade policies.7 this statement is true whether or not other governments followed suit and lifted their own trade restrictions .
Tariffs
A tariff (or a duty) is a tax that the government places on foreign imports . unilateral u . Yes. then this makes Americans poorer . usually the official justification for a new tariff (or a hike
We have to add the qualifier “(per capita)” because in theory. especially in the long run . a complete move to free trade—rather than removing individual barriers one at a time— would probably make just about everyone better off. now that we’ve outlined the general case for free trade. Having other countries “return the favor” is not needed in the argument for free trade.s . It is true that if China maintains its trade barriers against u . exports. But if there were particular producers who benefited from the trade barriers and were put out of business by foreign imports.s . removal of its own trade barriers would probably provide strong diplomatic pressure for other countries to follow suit. we can imagine particular individuals being hurt by the removal of trade barriers . In the real world.s . and so would other people around the world (per capita). total Chinese production and consumption would rise. We stress this point mainly so that you better understand the economic case for free trade .
7
. it makes foreigners better off. their individual losses as producers could conceivably be larger than their gains as consumers when they had far more options (and lower prices) in the stores .

s . demand for imported vehicles doesn’t lower the equilibrium price of $10..s . American producers could profitably expand their operations and provide more jobs for u .000 for a no-frills sedan . workers! the politicians are only too happy to oblige. In practice this is a slippery argument. etc . you should be aware of this technicality . so that American consumers can buy exactly as many cars at a price of $10. etc .000 out of pocket: $10. Because u .s .000 for Japanese cars in the world market . at the same (Japanese) price of $10.
A technical note: From the Japanese producers’ point of view.000 for Japanese sedans. the remaining cars are supplied by Japanese producers. and Japan. If you go on to study more advanced economics.8 and the other $1. that the Japanese government provides unfair subsidies to their car companies. But if you are going on in economics. could conceivably gain (while hurting the rest of the world) through the strategic use of low tariffs . u . car producers send their lobbyists to Washington . market .000 goes to the Japanese car manufacturer (as before).294
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in an existing tariff) is that it will help domestic producers of the imported good . American manufacturers can profitably produce some vehicles. suppose that initially there is completely free trade between the two countries.s . suddenly Americans don’t want to buy as many Japanese cars as they did the day before the tariff was erected .000 goes to Washington in the form of tariff revenue . and they slap a 10% tariff on any Japanese cars entering the u . they explain that labor costs are lower in Japan. let’s work with a concrete example involving the u .s . you will learn that this subtlety can give rise to the theoretical possibility of there being an “optimal tariff” in which a large country such as the u .
8
. It is this latter claim—that a tariff on foreign imports helps workers in the protected industry at home—that we will examine in this section . to make the analysis easier. using unrealistic but nice round numbers . At that price. and that the equilibrium market price is $10. that is. this means that if a u .000 as they want .s . but not enough to satisfy the demands of American consumers . we are assuming that this drop in u .” If only the federal government would impose a 10% duty on Japanese imports. and that Washington needs to “level the playing field . American demand for their cars has dropped . he now must pay a total of $11. consumer wants to buy a Japanese car. consumers are now being forced to pay $11. to keep things simple.s .s .000 per car. if for no other reason than that politicians couldn’t be trusted to stick to the “optimal” tariff structure .

the lobbyists were right! At the higher price of $11. because American car prices have gone up by $1. government imposes a tax on Japanese car producers. therefore. car factories. but it’s also true that u . not on foreign producers . then in a sense the payment of tariff revenues would be shared among American consumers and Japanese producers. producers can raise their own prices too . under fairly general assumptions.000 before. employment goes up in Detroit and other cities with u . It’s true that workers and shareholders in the u .000.
9
In practice. it’s actually misleading to say. if the new tariff caused the (pre-tax) market price of Japanese cars to fall. it’s easy to show that the benefits to the car producers are more than offset by the losses to the car consumers . the tariff makes Americans poorer .s . In our numerical example.000 as well .10
the new tariff also hurts some other American producers.s . just as the lobbyists predicted . car industry benefit from the new tariff. Any revenue that the u . even consumers who faithfully “buy American” are hurt. even
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.s . as we’ll see in the text .Lesson 19: Tariffs and Quotas
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it means u .s . “the u . producers move along their supply curve. In an introductory book such as this. u . government collects from the new tariff has come out of the wallets of Americans . And lo and behold.000—they are clearly worse off because of this change . Instead we’ll try three intuitive approaches to demonstrate that a new tariff makes the country poorer on average .” because the tax is really applied to American car consumers .s .s . but now they have to pay $11.s . because the out-of-pocket price of an import to Americans wouldn’t rise by the full tariff charge per car .
Tariffs Are Taxes on Domestic Citizens
Perhaps the most obvious way to realize that tariffs make a country poorer is to realize that tariffs are taxes on domestic citizens. car consumers are hurt by it . so is the new tariff an economic success? Most economists would say no .9 On net. After all. we won’t dot every i and cross every t in the argument . and manufacture more cars built in American plants by American workers . Americans who wanted to buy a car could get one for $10.

It Just Rearranges It
Perhaps the single biggest mistake in the protectionist approach is to believe that a new tariff increases total employment . consumers who actually spend the money collected by the tariff .s . the tariff interferes with that signal.s .11 People who think tariffs are a good way to boost the economy usually focus narrowly on the jobs that are “created” in the protected sector.s .
A Tariff Doesn’t Increase Employment. other u . and so forth . industries necessarily must shrink their output and produce it with fewer workers . though.
11
. But this belief is wrong. anyone
here. the original market price of $10.000 per car was a signal guiding consumers and producers as to the most efficient way to use resources . it’s worth stressing that it is u . In other words. In our example. but also at nearby businesses. it’s possible for one industry to expand.296
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everything we said about the distorting effects of sales taxes in Lesson 18 applies here. while others maintain their original levels of employment.s . In Lesson 23 we’ll explore the business cycle and see that this complication doesn’t change the conclusions in the text above . the one possible exception to this rule is that the unemployment rate could drop . And it is undeniable in our example that not only u . if the newly hired workers come from the ranks of the unemployed (or come from sectors which then replenish the lost workers from the ranks of the unemployed) . because a new tariff doesn’t suddenly create new workers out of thin air . what this shortsighted analysis overlooks is that jobs would be destroyed in other sectors spread around the country . and makes Americans act as if the rest of the world is less capable of producing cars than it really is . because a tariff is simply a sales tax on goods that happen to be produced abroad . and then further take into account all the extra jobs that are “created” when those new workers spend their paychecks at the mall. if the new tariff allows the u . auto industry to expand output and hire more workers. For one thing. would increase after the new tariff is erected . those who advocate tariff barriers to “protect” American industry are really saying that raising taxes on Americans is the path to prosperity . restaurants. employment at auto factories. However.

car consumers are “down” $1. consumers buy from Detroit rather than from Japan.s . specifically.000 being kept “in the country” rather than being “sent to Japan .s . because the (allegedly) big bonanza to u . if the government spends that money. for the reasons outlined in Lesson 18 .000 tariff payments sent to the u .000 compared to the pre-tariff situation . unless that country shipped them
What about the $1. car producers are “up” the same amount12—we should be focusing on the fact that for every additional u . right? Actually no . the clever protectionist might point out that we are here focusing on the small potatoes. in her neighborhood. software. In the text we are ignoring this complication because we want to focus on the other distortions caused by the new tariff .s .000 increase in car prices which is a wash—u . movie theaters.s . that’s $10. electronic goods. by the same token an entire country couldn’t continue to import cars. whereas u . sweaters. etc .Lesson 19: Tariffs and Quotas
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who buys a new car is out an additional $1. such a car buyer now has that much less money to spend on restaurants. thus the extra business of u . and so the merchants in her area suffer .s . car produced by American workers. it means Japanese citizens now have $10. and other exports .s . for every car that u . Just as an individual household couldn’t (in the long run) continue to buy goods and services from the outside world without producing something in return.000 less to spend on goods made in America . A crucial principle to remember is that a country ultimately pays for its imports with its exports. then this constitutes an additional distortion to the pure-market outcome. exports . and all sorts of other goodies from foreigners. imports.s . rather than focusing on the $1.” so surely this effect is the relevant one.
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. In other words.s .000 per car. and shows how the country as a whole benefits from the new tariff. the analysis of our clever protectionist is still overlooking one enormous effect of the tariff: By penalizing u . industry comes from switching so much business to domestic producers and away from Japanese producers . government for every Japanese car that Americans still decide to purchase? Well. the tariff simultaneously penalizes u . car producers is offset by the drop in sales among American producers of wheat.s . the best case for the protectionist is to assume that the government uses the tariff revenue to reduce other taxes on Americans .

what is really happening is that the country running the trade deficit is effectively borrowing against its future production . In the paragraphs above we “followed the money” just to show what the standard protectionist arguments overlook. and the producers they usually forget . In reality. A new tariff diverts u .298
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goods and services in return .
We have added the qualifier “in the long run” because an individual household could run up its debt by consuming more than it produces. and how much they can consume by either purchasing output from domestic producers or by trading surplus production with foreigners . Before leaving this section. we should emphasize an important point: Focusing on dollar amounts can be misleading. the significance of a tariff isn’t the effect it has on dollar bills—the number of dollar bills isn’t changed by a tariff law. But even here. so too does free trade make all participating nations better off .
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.13 to put it bluntly: the protectionist implicitly assumes that the Japanese car producers are idiots. Just as mutually beneficial trades make both parties better off. presidents . what makes Americans richer or poorer is how much they can produce with their own labor and other resources. and it’s ultimately not green pieces of paper that make Americans rich or poor . a country as a whole can run a net trade deficit if foreigners are willing to invest in its financial assets (such as buying stocks or bonds from corporations in the country running the trade deficit) . it hurts not only foreign countries but also the domestic population . and into industries in which they do not . It hinders the benefits of specialization among nations . because ultimately it is real goods and services that constitute the standard of living citizens enjoy . all in exchange for green pieces of paper featuring pictures of u . labor and other resources out of those industries in which they have the comparative advantage. no.s . at least for a while . By the same token.s . who are willing to bust their buns and use up scarce resources making beautiful new cars for Americans. When a government interferes with this pure-market outcome through the imposition of a new tariff.

For example. rather than imposing a 10% tariff on Japanese cars. who observed that in peacetime nations impose tariffs on themselves in order to keep out foreign goods. wouldn’t naval blockades make the enemy country prosper?
Import Quotas
An import quota is another popular form of government interference with international trade . the major economic effects would be roughly the same. but instead sets a limit on how many units can be imported . If u . then the legislators could in principle achieve roughly the same outcome on the u . and our analysis in the previous section would apply . the u .s . economy by simply setting an import quota equal to that number of vehicles . the government doesn’t directly interfere with the price of the imported good. Japanese producers would be allowed to sell 100. in practice import quotas are probably even more dangerous than tariffs. For these reasons. and they would receive the (distorted) market price without any of these expenditures flowing into the coffers of the u . But after the quota had been reached. In this arrangement. and because it is not as obvious how much damage they cause relative to the pure market outcome . Are Naval Blockades Great?
Perhaps the simplest argument to demonstrate the absurdity of tariff barriers was devised by Henry George.s . because they seem to burden foreign producers more than domestic citizens.Lesson 19: Tariffs and Quotas
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If Tariff Barriers Are Good. while leaving the ultimate determination of total imports up to the (distorted) market.s .000 vehicle quota . politicians
. legislators knew in advance how many Japanese vehicles Americans would import after they imposed a 10% tariff. government instead could impose a 100.000 cars in the u . government . market. If the protectionist arguments were correct.s . In that case. while in wartime nations impose naval blockades on other countries in order to prevent them from receiving foreign goods . the primary effects of an import quota are the same as those of a tariff . it would be illegal for any more Japanese cars to cross into the united states for sale . However.s .

it is not as easy to see how much the distorted pattern of production differs from the pure-market outcome. American consumers would not benefit nearly as much from cost-cutting foreign innovations . producers .
. If the foreign producers came up with innovations that allowed them to slash prices.300
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may be more likely to impose an incredibly onerous import quota. government . because the post-tariff price would fall . especially as time passes and conditions change .s . But with a rigid import quota. rather than an equivalent tariff . But if the government simply imposes an import quota. and then realize they are paying 50% more straight to the u . consider: under a tariff rate of 50%. to see this possibility. People can see what the original import price is. for example. then American consumers would still benefit if there were a tariff in place.s . it is quite visible how much the government is penalizing foreign producers and rewarding (particular) u .

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Lesson Recap •••
• Mercantilism is an economic philosophy that views the accumulation of money as the path to national prosperity. A group of people can only benefit when they are given more options.
. tariffs and quotas don’t “create jobs. and by the same token it makes perfect sense for different regions of the world to specialize in certain activities and trade surplus output with each other. on average. Contrary to the claims of their supporters. Mercantilism seeks to encourage exports and restrict imports in order to keep money within the country and to provide employment for domestic industry. • Tariffs and quotas are artificial government restrictions on foreign imports. but their gains are smaller than the harms imposed on everyone else. (A tariff or quota might benefit particular individuals in a country. It makes perfect sense for individuals to specialize in particular occupations and trade surplus production with each other.) In the long run. Free trade doesn’t force people to import goods from foreign producers. it merely removes obstacles. • The case for free trade among countries is simply an application of the general case for free markets. tariffs and quotas make the people in a country poorer.” they simply rearrange workers from more efficient into less efficient industries.

in the attempt to make one’s own country richer . measured in money . Beggar-thy-neighbor policies: Policies (usually involving currencies and trade restrictions) that make other countries poorer. In a zero-sum game. win-win outcomes are not possible . Zero-sum game: A situation in which the gain of one person (or country) corresponds to an equal loss of another person (or country) . It encourages exports and discourages imports . there are winners and losers . Free trade: An environment in which governments do not impose artificial restrictions on the flow of goods and services between their citizens and foreigners . Trade deficit: the amount by which imports exceed imports. mutually advantageous. Imports: Goods (and services) that the people of a country buy from foreigners . Trade surplus: the amount by which exports exceed imports.302
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new Terms
Mercantilism: the economic doctrine that views the accumulation of wealth as the path to national prosperity .
. measured in money . Exports: Goods (and services) that the people of a country sell to foreigners .

the government will encourage consumers to “buy local.Lesson 19: Tariffs and Quotas
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Protectionism: the philosophy that uses government trade restrictions in an attempt to help workers within the home country . Import quota: A maximum limit on the amount of a particular good that can be imported during a certain time period . the rationale is that by restricting foreign imports.” providing employment for local workers .
. Tariff (duty): A tax levied on foreign imports .

” 4.” 5. What historical role did Adam Smith play with respect to mercantilism? 3. it just rearranges it. Explain: “The economic case for free trade is unilateral.S. *Could every government successfully implement mercantilist policies? 2. Explain: “A tariff doesn’t increase employment. Explain the meaning (not the cause) of this statement: “The U.304
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sTudy QuesTions
1.”
. ran a trade deficit with Japan last year.

Drug Prohibition
D
rug prohibition refers to the severe penalties that governments often impose on the consumption and especially the production and sale of certain drugs . Instead the results of drug prohibition would
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. Drug prohibition is qualitatively different from u . punishable not only by huge fines but also lengthy prison terms .s . someone ignorant of economics would be at a loss to explain the pattern . In the modern American regime of drug prohibition. the possession and especially commercial distribution of drugs such as cocaine and heroin are outright crimes. state and local government’s current use of sin taxes —very high sales taxes—to discourage people from buying liquor and cigarettes . using the tools we have developed in this book.Lesson 20
The Economics of Drug Prohibition
In this lesson you will learn:
• The definition of drug prohibition. • Why drug prohibition fosters corruption and gang violence.
As the title states clearly. we will be able to understand why drug prohibition leads to a familiar pattern of results . • Why drug prohibition reduces product safety. in this lesson we are going to examine the economics of drug prohibition . In contrast.

ultimately.1
As with our analysis of other types of government intervention. However. the crucial question is this: “Would it be better to live in a society with or without extreme penalties for cocaine use?” In order to imagine what society would be like in one condition versus the other. We should stress at the outset that economic analysis by itself cannot judge whether drug prohibition is a good or a bad policy . it is important to learn what economic analysis says about the effects of drug prohibition . citizens and policy makers must incorporate their value judgments before deciding whether it is good or bad for the government to. We ignore arguments (for or against) based on a specific code of morality. in this lesson we are interested in pragmatic arguments by looking at the consequences of drug prohibition . having nothing to do with the government policies . the analysis below is designed to show the ways in which other things are not equal when the government engages in drug prohibition . say. Rather. that person isn't thereby condoning adultery . Remember that there is a difference between saying something is immoral versus saying it should be illegal . or a view of property rights and the proper scope of government action .
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. We are doing this because the positive consequences of drug prohibition are obvious and visible: Many people believe that the use of certain drugs is personally and socially destructive. and deaths from overdoses—things which most people would also deem personally and socially destructive . gang warfare. punish convicted cocaine dealers with 25-year prison sentences . and so they conclude that government policies which strongly discourage this behavior are (other things being equal) beneficial . because the government is powerless to stamp out cocaine use completely . If someone argues that cheating on one’s wife shouldn't carry a jail term. When it comes to illicit drugs. the question is not: “Would it be better to live in a society with or without cocaine?” that particular question is not relevant.306
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appear as random occurrences. the benefits of reduced and/or stigmatized drug use must be contrasted with the harms of police corruption. One final caveat before we plunge into the analysis: In the rest of this lesson we will be focusing on the (usually neglected) negative consequences of drug prohibition . in order for citizens and policy makers to make informed decisions. they must understand the full consequences of drug prohibition .

We should clarify. intended for personal use . governments try to stamp out the drug trade by inflicting much heavier penalties on suppliers rather than consumers . but many Americans would be shocked to learn that there is a (less severe) problem of corruption plaguing u . be they
these viewpoints are definitely important. and then we will see the scope for corruption .
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. the straightforward explanation for the connection between drug prohibition and corruption is that prohibition leads to huge monetary profits in the drug industry. Most Americans are aware of the widespread corruption in the Mexican and Colombian governments. corruption refers to government officials who do not execute their legal duties because they are secretly being paid by members of the drug trade whom they are supposedly combating . this emphasis is due to two main reasons: (1) If the goal is to limit total drug consumption. the professional drug dealer—especially the larger the operation—must deal with many other members of his industry. We are trying to understand how drug prohibition alters the original market outcome. courts and police departments . and (2) the public doesn’t mind harsh penalties on professional drug dealers. we must also consider that the likelihood of actually being arrested is much higher for a professional drug dealer.Lesson 20: The Economics of Drug Prohibition
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Drug Prohibition Corrupts Government Officials
In this context. these two factors explain why governments typically enact much higher penalties for those who are obviously drug dealers. as opposed to those who are caught with only a smaller quantity of the contraband. giving drug producers the ability (and of course the motive) to pay enormous bribes to government officials .s . simple economic analysis will illustrate why .2 After all. but they lie outside the scope of a textbook on basic economics . it is a better use of limited police resources to knock out one major supplier rather than the potentially thousands of customers who rely on him. typically. In addition to the higher official penalties on drug producers versus consumers. the likelihood of a professional drug dealer being arrested is much higher than for one of his customers were it not for bribes (“protection money”) regularly paid to the police . than for a casual customer . but would balk at draconian punishments of casual consumers .

000 in payoffs to act as lookouts and protection when what they thought were big drug deals were going down. in addition to the routine activity of providing security for purported narcotics trasactions. Prosecutors say the officers took up to $4. Attorney’s office. It turned out they were actually FBI agents. Ten sheriff’s correctional officers—sworn personnel that worked the jails and lockups— have been charged with criminal conspiracy. but 15 different law enforcement officers who sold out their badge in a greed [sic] for money to help drug dealers do their business. “An undercover FBI agent was able to deal with not one. the release said.” said U. Attorney Patrick Fitzgerald. All 17 were charged Tuesday with conspiracy to possess and distribute kilogram quantities of cocaine and/or heroin in eight separate criminal complaints unsealed following arrests early Tuesday.S. Seven of the eight complaints were supported by a single. according to a release from the U. 61-page FBI affidavit that outlines an undercover investigation that involved such activity as police officers protecting a high-stakes poker game. The Feds say the sheriff’s officers along with four police officers from Harvey and one Chicago cop were caught in an FBI sting. protecting transportation of large amounts of cash and two law officers actually selling powder cocaine.308
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Police Corruption: It’s Not Just a Problem for Mexico
The following excerpts from a 2008 news article about an FBI sting in the Chicago area illustrate the connection between drug enforcement and police corruption:
Seventeen people—including 15 south suburban police officers—have been charged in a federal probe of allegations that officers provided armed security for large-scale drug deals. The officers apparently thought they were protecting high-rolling drug dealers. not two.
.S.

followed the agent to a nearby parking lot. “Ideally. Patrick Fitzgerald said in the release.
. “And the involvement of some in off-loading and delivering what they thought were large shipments of drugs flown in by plane is particularly shocking. [The two officers].raid. operated by two other undercover agents.000 each—allegedly their most profitable payday in the corrupt relationship they began with the undercover agent at least a year earlier.2. Drug Dealing Probe. removed the duffels and drove away. four are Harvey police officers and one is a Chicago police officer. in a separate car. twin propeller engine aircraft flew on May 13 into west suburban DuPage Airport where three men awaited its arrival. Together. Of the 17 defendants. They boarded the aircraft. [The two Cook County correctional officers] and the undercover agent removed the duffels from the plane and took them through the airport lobby to the trunk of the agent's car in the parking lot. accompanied someone whom they believed brokered large-scale drug transactions but. The FBI agent posing as the drug broker then paid [the officers] $4. “15 Cops Charged in FBI Sting. it should be hard to find one corrupt police officer and it should never be easy to find 15 who allegedly used their guns and badges to protect people they believed were dealing drugs instead of arresting them.html.”
Source: CBS 2.” U.S.police. according to the affidavit.” December 2. Atty. was an undercover FBI agent. They allegedly accepted between $400 and $4. 10 are Cook County Sheriff’s correctional officers.Lesson 20: The Economics of Drug Prohibition
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According to a release.com/local/harvey. in fact. a six-passenger. 2008 at: http://cbs2chicago.000 each on one or more occasions to serve as lookouts and be ready to intervene if real police or rival drug dealers attempted to interfere with transfers of cocaine and heroin. . and began counting packages of what was purported to be at least 80 kilograms of cocaine inside four duffel bags. . Two of them . where the agent parked and got into the officers' vehicle. the release said. the affidavit alleges.877798. the trio watched as yet another undercover agent arrived.

market for cocaine . Because of these disparities in the effective penalties facing drug producers versus consumers.000 grams
Q
Market for Cocaine
.s .000 grams 1. the following diagram illustrates the hypothetical unregulated. anti-drug forces should penetrate any portion of this extensive operation. and then sells fractions of what gets through to the heads of regional drug gangs in California .” hires Mexican truck drivers to smuggle it across the u . the particular dealer would be vulnerable to arrest . If Colombian.000. versus the actual payment that the end users give in exchange— becomes quite high . the supply of illegal drugs falls much more than the demand. there is much less chance of his life being ruined by government punishment for his involvement in the drug industry . relative to an initially unregulated market . and he only interacts with other “small fish” such as a neighborhood dealer . meaning that the monetary “markup”—the difference between the monetary expenses to produce the product. versus prohibited. or u . For example. this pushes up the new equilibrium price of illegal drugs. one member of the drug trade might run an operation where he buys cocaine from Colombian “wholesalers. the casual customer is really only at risk when he needs to purchase more product. In contrast.310
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higher-level suppliers or lower-level retailers .s . border.
P $100
s2 s1
$1 D1 D2
10. His entire workday involves the habitual violation of anti-drug laws . Mexican.

producers want to sell 1 million grams of cocaine. the huge markup must remain. that is. the supply curve in the diagram above shifted to the left because of the non-monetary risks associated with remaining in the cocaine business .000 grams and consumers want to buy the same amount .
The Significance of “Victimless Crimes”
It is important to note that the scope for government corruption due to drug prohibition is much larger than for more traditional crimes such
. the quantitative shift is much greater on the supply side than the demand side . the higher price paid by customers will therefore not translate into higher prices paid to the farmers in Colombia who harvest coca . After the imposition of strict drug laws. it’s not true to say that “it’s now more attractive than before to become a cocaine dealer . for a given dollar-price of a gram of cocaine. this principle is not unique to illegal drugs—coal miners and taxi drivers (who are often robbed) receive an implicit form of hazard pay as well .” People choose occupations based on many factors. and consumers want to buy 1 million grams . At that price. producers are willing to offer much less than before (since they now risk going to jail). we see that the unregulated market price of cocaine is initially $1 per gram . It’s more accurate to say that because of the new government penalties (and presumably the corresponding social stigma). in order to make it worthwhile (in the eyes of some) to remain cocaine producers even in the face of significant penalties . but the government judicial system . the difference is that with illegal drug dealers. In the new equilibrium. only one of which is how much money they will typically earn . where producers want to supply 10. the “salaries” of drug dealers had to skyrocket in order to compensate for the new downsides of the profession .Lesson 20: The Economics of Drug Prohibition
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In the previous diagram. the supply and demand curves for cocaine both shift to the left . A crucial point is that the monetary profit will remain high. no. the hazard comes not from nature or muggers. and consumers are not willing to buy as many grams either . However. even years after the drug prohibition has gone into effect . that is why the new (prohibition) equilibrium has a market price of $100 per gram.

respondents reported using the drug within the last year . to understand this disparity. But there is a definite sense in which the production and consumption of drugs is qualitatively less victimizing than traditional crimes such as homicide.gov/drugfact/cocaine/cocaineff . Yet criminal gangs do routinely pay off police and other government officials in order to run major drug operations with official (though of course discreet) protection .whitehousedrugpolicy . as they would for ignoring their official responsibilities to prevent nonconsensual crimes against person or property . Indeed in the united states. judges. and other government officials won’t feel as bad “looking the other way” for someone who supplies desired products to willingly paying customers.” Because it is victimless in the
see http://www .html# extentofuse . this feature has two major implications. we need to reflect on the common remark that illegal drug transactions are “victimless crimes . Regarding marijuana. see http://economix . and robbery .blogs .s . the difference is that in a “victimless crime”—which in the united states includes not only drug transactions but activities such as gambling and prostitution—all parties to the transaction are voluntary participants . both of which help explain the connection between drug prohibition and corruption . than in the hit man or even bank robbery “businesses . to talk of a “dirty cop” is almost synonymous with one who takes drug money. since children are certainly victims if their father loses his job and becomes abusive due to addiction . the drug trade is after all a business .3 there is quite simply much more money in the drug business.com/2009/08/11/drug-useacross-the-united-states-or-rhode-island-needs-more-rehab/ . second. a survey conducted between 2006 and 2007 found that more than 10% of the u . First. According to the Office of national Drug Control Policy.312
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as homicide and robbery . and 2% had used cocaine within the past month . there are many millions of people in the united states who willingly spend their money on illegal drugs on a regular basis .
3
.” naturally the supporters of drug laws would reject this phrase as an inaccurate cliché. rape. there is the simple fact that police officers. no one would think that the term might refer to a police officer who is regularly paid off by contract hit men so that they can murder with impunity 6 days a week . a 2007 survey showed 6% of young adults reported using cocaine within the previous year.nytimes .

then supply and demand could be reduced so much that the new equilibrium quantity of. the scope for corruption due to drug prohibition is far larger than for traditional crimes. the drug trade can be much more easily kept quiet than crimes with explicit victims who would call the police— and might get someone who wasn’t on the criminals’ payroll—or. Government corruption is both a consequence and a cause of illegal drug trafficking . failing that. If the penalties were high enough and consistently enforced. this difference by itself doesn’t prove that drugs should be legalized. and the difference stems from the “victimless” nature of drug crimes . could go to the media and complain . and in that sense is a cause of it . giving them the wherewithal to bribe government officials who otherwise could arrest them .
Corruption as Cause and Consequence
Most people abhor systemic government corruption because it breaks down traditional respect for the law and makes citizens more likely to commit crime . However. this skyrocketing price allows entrepreneurs to earn millions of dollars annually. but it does show a problem of drug prohibition that is not nearly as rampant with other crimes . because the government
. why not legalize murder too?” As we have shown above. However in the context of drug prohibition there is a much more specific dynamic at work . We mention these differences to deal with a standard defense of drug prohibition which says. it’s also true that corruption is a necessary component of illegal drug trafficking. cocaine production and consumption would be zero . “Well if we should legalize drugs because of corruption. Yet in practice this rarely happens. this is the sense in which corruption is a consequence of illegal drug trafficking . Here’s how the feedback cycle works: We have already seen that drug prohibition typically raises the market price of (newly illegal) drugs. In truly oppressive regimes—such as Afghanistan under taliban rule—the drug trade can be snuffed out by the government .Lesson 20: The Economics of Drug Prohibition
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important sense defined above. say. because the supply curve shifts left far more than the demand curve .

alcohol was still produced and distributed by bootleggers. Worse still. often in the form of gang warfare . under drug prohibition in relatively free societies.
Drug Prohibition Fosters Violence
everyone knows that the illegal drug trade is plagued by excessive violence. the casual observer might conclude that drugs such as cocaine and heroin are intrinsically bad. Although Prohibition didn’t eliminate alcohol use.
the eighteenth Amendment was actually ratified in 1919. when they might be offered literally hundreds of thousands of dollars per year to shirk their official duties .314
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itself can’t police its own employees.4 the sale.
Alcohol Prohibition in the United States
the historical evidence is clear enough in the case of alcohol Prohibition . From 1920 to 1933. but alcohol Prohibition did not take effect until 1920 . and transportation of alcohol (for purposes of consumption) was illegal in the united states .
4
. and thus the supply curve for illegal drugs does not shift as much as it would in the absence of corruption . Yet despite the official illegality. and go hand-in-hand with violence . Yet this explanation is wrong . to put it succinctly. the supply curve shifts left until the new market-clearing price is high enough for the remaining producers to afford adding narcotics officers and judges to their payrolls . innocent bystanders are often killed as collateral damage from turf battles between rival drug dealers . and drinkers could still gather socially at speakeasies . Widespread corruption allows drug criminals to escape the huge official punishments that the law books require. not drugs per se . it did place the industry under the control of organized crime . Both economic theory and American history demonstrate that drug prohibition causes violence. under the eighteenth Amendment to the Constitution. During the Prohibition period— often called the “noble experiment”—mobsters such as Al Capone (based in Chicago) derived significant revenues from the illicit alcohol trade. manufacture.

not to the nature of the products themselves .Lesson 20: The Economics of Drug Prohibition
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money that they used to bribe government officials and hire “soldiers” and other henchmen for their criminal networks . Valentine’s Day Massacre was a 1929 gangland hit in which Al Capone arranged for the murder of seven members of rival Bugs Moran’s operation . Can you imagine turning on the television tomorrow and learning that the distributors of Budweiser had ordered a hit on the distributors of Heineken? that would be inconceivable . the infamous st . its producers try to gain market share by improving the product quality or cutting its price . what activities do we see in the hands of criminal organizations? they include drugs such as heroin and cocaine. but all agree that Capone and Moran were enemies due in part to rivalry in the bootleg market . but instead by legitimate businessmen and women . and loan sharking . the important feature of alcohol Prohibition was that the alcohol trade could be as violent as the heroin or cocaine trade is today . It wouldn’t even occur to them to use violence to gain more customers . If you have seen movies or read true crime accounts dealing with Prohibition-era gangsters. Historians cite various motivations for the slayings.5 In short. On the other hand. the historical episode of alcohol Prohibition provides very compelling evidence that the violence we currently associate with illegal drugs is due to government’s prohibition.
5
. now that alcohol is legal. In the remainder of this section we’ll explain this undeniable connection using economic reasoning . Yet on the surface it should be shocking that rival entrepreneurs would try to kill each other over alcohol . all areas that are still (unlike alcohol since the repeal of Prohibition) either prohibited or heavily regulated by the government . gambling. these historical events are familiar and do not cause any puzzlement . prostitution. Alcohol is no longer controlled by organized criminals. For our purposes.
A loan shark refers to someone who makes short-term loans at very high interest rates (which may violate usury laws) and popularly resorts to physical punishments in order to ensure repayment .

a cocaine dealer sees an enormous increase in his total monetary earnings if he can add a handful of regular users to his customer base .” and into this anarchy violent gangsters flow . this increase in price translates into a much greater benefit from boosting sales and controlling a greater share of the retail market . Among its other consequences. meaning they are the same whether he sells 10 grams of cocaine per day or 100 grams . drug prohibition increases the benefits (on the margin) from using violence to intimidate or actually kill competitors . Amazon. Because it makes individual customers so much more lucrative.316
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Drug Prohibition Raises the Marginal Benefits of Violence
We have already seen how prohibition raises the monetary earnings of drug dealers . whereas legitimate businesspeople almost never resort to violence as a means of competing . such explanations have things backward . In a typical treatment of the economics of drug prohibition. legal market. the writer will often explain that producers in prohibited industries cannot rely on police protection and contract enforcement. competition tends to drive down the price until the monetary returns are comparable to that of other projects . there are plenty of commercial relations in everyday life that are not protected by government courts . Americans spend billions of dollars per year buying items—often of high value—from perfect strangers who
. In a regular. using eBay. this is one of the major explanations for why prohibited industries tend to be rife with violence. and other mechanisms. namely the risks of going to prison or being killed by a rival dealer . And note that this feature is greatly amplified by prohibition itself. In contrast. because when cocaine distribution is illegal. and so must resort to private violence to protect their merchandise . most legitimate business owners don’t see significant increases in their monetary profits by “stealing” a few customers away from their competitors . the primary “business expenses” are mental ones. this is because the expenses in his business are largely fixed. explanations of this sort often cast the drug industry as one suffering from “government neglect. Because there is usually such a small “markup” from the production expenses compared to the retail price.

then the market price of drugs in these areas would fall to (nearly) the monetary production costs. this observation is surely only incidental . (the process could unfold in stages if the Colombians wanted to make sure they weren’t double-crossed . but they definitely enforce drug laws. if only sporadically—that’s why the market price stays high.” so we see that it is not government neglect.) the reason drug dealers currently can’t operate in this fashion isn’t that they fear a bank will steal their money and then the drug dealers won’t be able to call the police . the average dry cleaner doesn’t worry about a rival from across town spraying his shop with machine gun
Indeed. because he can’t look to the police for protection . anyone with the temerity to enter the industry and try to earn significant amounts of money must himself become heavily armed and gain a reputation for ruthlessness. allowing drug dealers to buy fancy cars and expensive jewelry . It doesn’t explain why the drug industry is rife with violence in the first place. nobody—even people unconnected with the drug trade—would use that bank again . even in inner city projects . a cocaine retailer could deposit $1 million with a reputable financial institution. the first time that happened. But again. In reality drug dealers can’t use the simple mechanism we’ve described because of the risk that the government would seize their funds as “drug money . but government enforcement of drug laws.Lesson 20: The Economics of Drug Prohibition
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might live across the country . which would agree to transfer the funds to a Colombian wholesaler once the retailer had received his goods . It is true that given the prevalence of violent drug dealers. the number of violent drug deals “gone bad” would plummet . Rather than bringing suitcases of cash (along with heavily armed bodyguards) to parking garages in the dead of night. if drug dealers could conduct major transactions using electronic payments routed through a universally respected third party. On the contrary.
6
. that makes violence more appealing in the drug trade . it is precisely these industries that receive the most government attention! It is simply not true that the police ignore drug dealers. and young teenagers would find being a drug dealer to be no more lucrative than becoming a paper boy . the police are not viewed as friendly servants of the public in certain drug-ridden neighborhoods. but in practice these transactions are largely “self-policing” through the private-sector hosts and the sometimes elaborate system of reputation that they develop . In principle someone could file a lawsuit in the event of fraud.6 It is completely inverted to view prohibited industries as suffering from a lack of police and judicial oversight . If it were true.

” Finally. Another important consideration is that the illegal drug dealer must develop a network of relationships with criminals. he would be under no threat of going to jail for the rest of his life . If cocaine and other drugs could be sold legally. it’s not as if he would trust the top hit when searching Google for “contract killer . drug prohibition makes it “worth it” for cocaine producers to kill each other . the real reason that dry cleaners don’t compete using violence is that it wouldn’t be worth it .318
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fire. he does not worry nearly as much that violent acts will ruin his social standing in respectable circles—he forfeited that option when he decided to become a large-scale drug dealer . he could travel in respectable social circles. As a legitimate businessman. and assuming he had paid his taxes properly. In contrast. allowing him to much more easily recruit “soldiers” or arrange for professional hit men to carry out violent attacks on his rivals . In this situation. then retail shops could operate safely even in the toughest of neighborhoods using
. no. committing the heinous crime of paying to have someone murdered would be incredibly risky . the legitimate businessperson would probably have no idea how to have someone murdered with little chance of being caught. Because he must associate with other habitual lawbreakers. In contrast. or become the target of higher-level government officials whom he cannot bribe . In contrast. the head of a cocaine distribution network has already committed more than enough crimes to go to jail for life if he should ever fall out of the good graces of the police on his payroll. prohibition lowers the cost of an individual violent act .
Drug Prohibition Lowers the Marginal Costs of Violence
Another aspect to the connection between violence and drug prohibition is that on the margin. and his confidence in this regard is not simply that he could call government detectives who would find and punish the drive-by shooters after the fact . Consider this: Part of the reason that a major Budweiser distributor wouldn’t take out a contract on the life of his Heineken rival is that such a move would completely transform his own life . the nature of the black market makes violence a much more practical option .

People who in other walks of life would have been unemployable suddenly have an opportunity to use their “talents” to earn millions of dollars . By discussing the changing benefits and costs of engaging in violence. Because the prohibited drug trade attracts violent individuals who think of immediate payoffs and disregard long-term consequences. In contrast. there is a dynamic at work in which violence begets violence in the (prohibited) drug trade . and that it was the change in government policy that transformed mild-mannered executives into ruthless crime bosses . and at corrupting government officials . these are indispensable skills . But it is also worth noting that violence from drug consumers will also tend to rise because of prohibition. the supply of (illegal) drugs shrinks further and further.
The Feedback Loop of Violence
As with corruption. conventionally defined. driving up the price . they are not necessarily the best businessmen. Yet this creates an opportunity for new entrepreneurs to enter the market . they probably couldn’t compete in a normal market and rise to the top . with drug prohibition the “employees” of drug operations often operate on the streets. it should come as no surprise that over many years. Yet what they are good at is outwitting and outmuscling their competitors. Obviously this is not the real story . As more and more of them leave. In the prohibited drug industry.Lesson 20: The Economics of Drug Prohibition
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security measures such as bulletproof partitions separating customers from employees . making it less costly for their competitors to attempt to wipe them out . When there are addicts willing to do just about anything
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Violence From the Consumer
thus far we have focused on the violence coming from producers in the drug trade . In practice what happens is that drug prohibition chases away honest and nonviolent people from the industry . we may have made it seem as if the same people would sell drugs with or without drug prohibition. simply because of the huge price increase . prohibition fosters a subculture of gang warfare .

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. as well as to make concealment easier.cato . 1991. citizens should think twice before recommending government policies that make cocaine up to 1. For example. relative amateurs make the product.000 times more expensive than it would otherwise be .” Cato Institute Policy Analysis no .org/pubs/pas/pa157 . there is nothing like a sealed bottle with “tylenol“ stamped on it to vouch for the safety of the contents and to clearly explain the proper dosage . Five years later. Because of the difficulty in building up name-brand recognition. He will tend to grow those strains that have the highest potency and hence the highest market price
Death statistics and Will Rogers quotation from Mark thornton.064 . deaths from liquor poisoning had quadrupled to 4. in 1920—the year alcohol Prohibition was introduced in the united states—the national death toll from liquor poisoning was 1. 157. For example. a drinker during Prohibition might switch to whiskey rather than beer . July 17. this effect also operates—and probably much more heavily— on the production side . Another problem is that illegal drugs are typically transported in generic packaging . Another factor to explain the rise in overdoses is that the consumers of illegal drugs tend to seek out more potent forms to get their fix .”7 the economic explanation for this pattern is straightforward . “Alcohol Prohibition Was a Failure. such results led Will Rogers to quip that “governments used to murder by the bullet only . Consumers consequently have to take their chances and hope that what they buy won’t end up killing them .320
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to get their next fix. now it’s by the quart . the truly safe (illegal) drug producers cannot capture as much of the market as they would without prohibition .
Drug Prohibition Reduces Product Safety
Yet another unintended consequence of drug prohibition is the increase in injury or death from product impurities or consumer mistakes . this makes quality control difficult and reduces product purity . at: http://www .pdf . often in their homes (depending on the drug) . someone growing marijuana in his closet only has so much space to work with .154 . under prohibition. In order to minimize the number of illegal purchases.

Unintended Consequences of Alcohol Prohibition
Irving Fisher was a famous University of Chicago economist who was a very strong supporter of alcohol Prohibition.” Cato Institute Policy Analysis No.” —Irving Fisher. is that bootleg liquor is so concentrated and almost invariably contains other and more deadly poisons than mere ethyl alcohol. the proportion of “jumbo” to normal-sized shrimp would probably increase in the black market. Yet Fisher himself reported: “I am credibly informed that a very conservative reckoning would set the poisonous effects of bootleg beverages as compared with medicinal liquors at ten to one. “Alcohol Prohibition Was a Failure. 1991
. it requires only a tenth as much bootleg liquor as of preprohibition liquor to produce a given degree of drunkenness. of course. compared to their proportions in a legal market where retailers could store their shrimp in large refrigerators . quoted in Mark Thornton. The reason. For an analogy. July 17. if the government decided to prohibit the sale and consumption of shrimp.Lesson 20: The Economics of Drug Prohibition
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per weight . 157. that is.

” prohibition leads to police corruption. Because the illegal drug trade is so lucrative. which leads to more overdoses and other health problems. without thereby condoning adultery. the incentives of prohibition lead producers and consumers to shift to “harder” drugs. In addition. • Drug prohibition raises the marginal benefits and reduces the marginal costs to drug dealers of using violence against their competitors. In the case of illicit drugs.322
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Lesson Recap •••
• There is an important distinction between activities that are immoral and those that are illegal. it is a coherent position to support legalization while personally condemning drug use. (Someone could think infidelity shouldn’t carry a jail term.
. leading to huge monetary (accounting) profits.) • Prohibition raises the market price of the drugs. and because it is a “victimless crime.

but also to encourage people to reduce their purchases of these dubious items . For example. Sin taxes: High sales taxes on goods such as cigarettes and liquor that are imposed not merely to raise revenue. In some cases police officers have simply robbed drug dealers (of cash) at gunpoint. Fixed costs: Monetary expenses that do not increase when a business expands output . and so this is a fixed cost . Hazard pay: the higher earnings necessary to attract workers into an industry that is more dangerous than others .Lesson 20: The Economics of Drug Prohibition
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new Terms
Drug prohibition: severe penalties that the government imposes on the consumption and especially the production and sale of certain drugs . Loan sharking: the practice of lending money at high interest rates and using illegal methods to obtain repayment .
. the failure of police and other government officials to execute their duties. a barber shop’s monthly water bill will be roughly the same whether it provides 1 haircut or 100 haircuts per day. Corruption: In the context of the drug trade. Usury laws: Price ceilings on interest rates . either because they are accepting bribes from drug dealers or because they themselves are trafficking in prohibited substances . knowing that they had no recourse .

In what sense do cocaine dealers (under drug prohibition) earn hazard pay? 3.324
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sTudy QuesTions
1. How does drug prohibition raise the marginal benefits of using violence for drug dealers? 5. *What is the connection between corruption and a “victimless crime” such as cocaine distribution? 4. How might drug prohibition contribute to fatal overdoses?
. What role does economic science play in the analysis of drug prohibition? 2.

over the course of the 20th century the term gradually came to signify the general increase in prices of goods and services in the economy . We will ignore this complication . this is a very technical issue having to do with the fact that banks are legally allowed to grant more loans than they actually have cash in the vault . Historically.1 However.
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. to avoid confusion. the term inflation referred to an increase in the amount of money in the economy . • How government intervention makes prices rise.
Money Inflation versus Price Inflation
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eople use the term inflation all the time. in this chapter we will use the more specific terms monetary inflation and price inflation. and yet they don’t always agree on what the term means . • The harmful effects of price inflation. this arrangement is described as a fractional reserve banking system .Lesson 21
Inflation
In this lesson you will learn:
• The difference between monetary inflation and price inflation.
some economists would say that the term inflation refers to an expansion of the amount of money and credit in the economy .

In fact. In the next section we will go over the basic economics of price inflation. aggressive labor unions. 1965). in order to make sense of the correlations Friedman (and others) have found between (a) growth in the money stock and (b) growth in the prices of most
throughout this chapter. they are not referring to the “supply curve of money. or a government running up its debt . To use it to mean ‘a rise in prices’ is to deflect attention away from the real cause of inflation and the real cure for it. It meant that the volume of money was inflated. People often blame price inflation on greedy companies. blown up. When people are comparing money to prices. they almost always mean how many actual units of money are in the economy. overextended. “Inflation is always and everywhere a monetary phenomenon . But what Friedman had established was that historically. he also found a rapidly increasing stock of money . 2
the two phenomena—a rising stock of money2 and a general rise in prices—typically go hand in hand . It is not mere pedantry to insist that the word should be used only in its original meaning.” a concept that would actually be difficult to even define in modern economies where the government has intervened so heavily in the area of money . p. —Henry Hazlitt. lasting price inflation could only happen if the amount of money in the economy grew as well .326
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The Old Switcheroo
The word ‘inflation’ originally applied solely to the quantity of money. What You Should Know About Inflation (New York: D.
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. after documenting the very tight historical correlations—across the centuries and across the world—the economist Milton Friedman famously summarized his research by declaring.” What Friedman was saying is that whenever and wherever he had found long-term and rapid price rises in his research. in order to avoid confusion . Van Nostrand. we will use the term stock of money rather than the more usual money supply.

gasoline. which is a particular measurement of the money
.) in order to come up with a rough comparison between “the price level” in different years . We should stress that there is not a precise one-to-one connection between money and prices. whenever there has been a period of long-term price rises.200 1.org
CPIAUCNS. if the amount of money goes up by 10 percent in one year. we can’t automatically assume that the prices of all (or even most) goods and services will rise by a comparable amount . recessions 2010 research . 1960–01 = 100 MINS. etc . the following chart shows the relationship between money and prices in the united states over a 50-year period:
Consumer Price Index for All Urban Consumers: All Items (CPIAUCNS) M1 Money Stock (M1NS) 1. We are making the weaker claim that across history and across countries. CPI (the gray line) refers to the Consumer Price Index which is a standard index used to gauge movements in prices . the black line in the chart is M1. 1960–01 = 100
In the chart above.000 800 (Index) 600 400 200 0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
shaded aeas indicate u .stlouisfed .s .Lesson 21: Inflation
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goods and services . the CPI takes an average of the prices of typical items in the united states that consumers purchase (such as food. For example. there has also been long-term expansions in the amount of money in that economy .

3 now picture an economist who was an expert on the history of u . the chart shows that for the first 24 years (from 1960 through 1984) CPI and M1 grew at similar proportions . at least as gauged by the CPI . but rather we accounted for the exponential growth involved (multiplying percentages by percentages) . the connection between the two series utterly breaks during the financial crisis of 2008. we are saying that in general. to make sure you understand what these numbers mean. the two series had increased by almost the exact same proportion . since the mid-1980s. to be specific. the units of the vertical axis of the chart are an index. going all the way back to 1960. but the different growth rates tended to balance out so that after 23 years had passed. whereas prices hadn’t doubled until early 1977—but the connection seems quite strong between the two series . for an average yearly rate of price inflation of more than 8% for five years in a row . set to 100 for the first point on the chart. sure.
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. notice in particular that the rapid price inflation of the late 1970s was matched with a comparable increase in the money stock . from January 1975 through January 1980. sometimes one series would rise faster than the other. someone who thought economics was all about careful measurements and statistical correlations might think he had discovered the economic equivalent of the charge on an electron . while M1 rose 40% .
If you are a math whiz. At that point. the money stock grew a bit more quickly— it had doubled from its initial 1960 value by the end of 1975.328
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supply that includes actual paper currency as well as the total amount of checking account balances held by everyone in the united states . something that cost $10 in early 1975 would cost about $15 just five years later. the stock of money—at least as gauged by the particular measure M1—has risen far more quickly (in percentage terms) than prices. we point out that we have calculated the average compounded annualized growth rates . when M1 shot up sharply while CPI declined . money (as measured by M1) and prices in the year 1983 . However. the chart shows what happened . In other words we didn’t simply take the total percentage growth and divide by 5. he would have believed there was a very tight connection between M1 and CPI . namely the values of CPI and M1 on January 1960 .s . CPI rose 49%. And of course.

Yet as the chart on page 327 shows only too well. and would melt them down . Instead governments throughout the ages have systematically debased the currency—meaning they reduced the market value of each unit of money—while enriching themselves .
How Governments Make Prices Rise
In Lesson 7 we laid out the general explanation of money in a pure market economy . If people’s values and beliefs about certain things remain roughly constant over a period of years. whenever there has been significant price inflation— especially hyperinflation when prices rise at inconceivable rates. everything in the economy ultimately occurs because of individual human actions which are guided by people’s subjective values and beliefs . throughout history. In an introductory book such as this. i . For example. in the next section you will learn how basic economic tools can be applied to money and prices. Yet those laws can be shattered in an instant when the actual human beings change their preferences or their beliefs about the future . You will probably not be surprised to learn that historically. We saw that the same principles of economics applied to goods such as gold and silver when they became money. then they would add in some baser metal. widely accepted media of exchange . and have their mints produce more coins than the original number. Over time. such as one million percent (or more!) per year—we always find that the money stock rises significantly during the same period . then statisticians might discover apparent “laws” connecting various measures of economic activity .. we will not try to explain the exact patterns in the chart above . and yet keep the official markings of the coin the same . government rulers did not leave the “money market” alone . which will at least provide the framework for a fuller understanding . However. the Caesars of ancient Rome would engage in the following process: they would take the gold coins that were paid as tax tribute.Lesson 21: Inflation
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We are discussing the chart above to make sure you understand the lessons and limitations of the empirical work on monetary and price inflation .e . there is not a mechanical rule connecting prices with the stock of money . this process ensured that the “gold” coins that were used in commerce actually had
.

if the government took the original coins and transformed them into 1. But through the trick described above. of course. was that at least initially—before the merchants realized the full extent of the debasement—the Roman government could afford to buy more things than without debasing the currency . strictly control the number of green pieces of paper of varying denominations and (to a lesser extent) the total deposits in all checking accounts that are measured in u . if the government originally collected 1. For example. gold coins would not be pure gold. without resorting to debasement they could afford to buy…1. the Federal Reserve. because they would be too malleable .s . For example.
The Rise of Fiat Money
As you probably realize. an arms race of sorts developed . Once the merchants began to catch on to this scam. the merchants could raise their prices expecting further debasement. But there is nothing to “guarantee” the value of the dollar .330
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progressively smaller amounts of actual gold in them .s . government and the central bank. so that what used to cost “one gold coin” would eventually cost several “gold coins . governments around the world gradually moved away from monetary systems anchored on precious metals .
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. the u . dollars . in the united states the official money is the u .000 gold coins in taxes.4 Merchants became aware of this and would adjust their prices accordingly. today all major economies are based on fiat money which refers to governmentsponsored money that is not “backed up” by any goods from the market . then obviously the government could obtain more goods and services from producers in the community .100 coins that superficially appeared to be the same as the original batch. dollar . some amount of baser metal would be added to keep the coins durable and useful as money .000 gold coins’ worth of goods .s . the inevitable result was that prices in the Roman empire grew quite rapidly . but there was nothing to stop the Roman government from accelerating the pace of the metal dilution .” the point of this procedure.
note that even without debasement.

it was not always so . four fives. a very germy bookmark at that . is simply that…they expect other people will do the same in the future . and the government can print bills with more zeroes on them to achieve any amount of new money at a negligible expense . If you walk up to the u . cleaning off a table just for him. treasury or a Federal Reserve Bank. all in order to get their hands on more of these green pieces of paper that are intrinsically useless . and then bring him all sorts of delicious food and tasty beverages . he thinks other people will take orders from him because of his stockpile . In other words. and that merchants are willing to sell their goods for dollars. this is an awesome amount of power to be vested in the hands of a single group. so on the surface. Although modern economies are all based on fiat money. One person will prostrate herself so much as to introduce herself by name and say she will be serving the man . or twenty singles . dollar is simply the u . the reason workers are willing to give up their leisure for dollars.s . “now what do I get?” they will tell you. and even kill each other. It’s extremely easy for the u . Which do you want?” this is a very strange arrangement when you think about it . then. even a $100 bill by itself isn’t good for very much besides being a bookmark—and even then. “Bring me some eggs. and say.s . government to print up more dollars.s . “either two tens. that is. and for the same reason that he himself took orders from the loudmouth at his own job . government in any way . the man will say. Possession of the green pieces of paper enables him to be the boss. dollar .s . rob banks. the reason a man will spend 40 hours a week taking orders from a guy he can’t stand. the people in the building will obey him .Lesson 21: Inflation
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the u . is that he will get a pile of dollars in exchange for these services . Of course.” and lo and behold. it’s extremely odd that these little pieces of green paper are some of the most coveted things on the planet . the cost is just a few pennies to buy the paper and ink necessary. the dollar doesn’t entitle the holder to anything else—it’s not a legally binding contract or a claim on the u .s . and it’s interesting to see how things came to this . Clearly whoever is in charge of creating these green pieces of paper has a very nifty operation . hand in a $20 bill. He’ll walk into a building and people will snap to attention. People are willing to work grueling hours in a hot factory. In Lesson 7 we learned how market commodities (such as gold
.

currency would entitle them to one ounce of gold .s . thus the paper dollars themselves weren’t the true money. the colonists were using gold and silver coins as money . the government was legally obligated to hand over physical gold to people who presented it with paper dollars .s . and other commodity monies were in themselves actual goods in the market that people subjectively valued even before they had achieved their status as money . In a pure market economy. other governments (and their central banks) could still hand in u . the u . dollars for gold.332
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and silver) could emerge spontaneously from an initial barter economy and eventually become money . it’s true that part of the reason people would work hard for an ounce of gold was simply that others would work hard for that same ounce of gold in the future . gold.
5
. for example. Historically. For the next several decades. government only because originally these were claim tickets on the preexisting commodity monies . the significance of a fiat versus a commodity money is that it’s so much easier to increase the amount of fiat
the history of gold and silver legislation in the early united states is quite complicated and lies outside the scope of this introductory book . various people could own gold mines. dollar. President Franklin D . In such a situation. it meant that the entire world economy was now subject to fiat monies . But beyond that. dollar has been a true fiat money. Americans began using pieces of paper connected to the u . From that point onward. in the same way that the total amount of bicycles isn’t set by a government agency . In terms of the basic economics.” no.67 in u . from 1834 through 1933 (with very minor exceptions). the important point is that even before the Constitution was written. namely gold . backed up by nothing .s . Roosevelt formally ended the government’s promise to redeem dollars for gold .5 In 1933 after his inauguration in the depths of the Great Depression. but Richard nixon closed even this avenue by officially severing the dollar from gold in 1971 . governments took over control of the money by first issuing paper currency that was linked to gold and/or silver . For example. silver. this wasn’t merely a prediction or a hope on their part. there is no single agency in charge of “the money . and thus the total amount of money in the economy was determined in the open market through supply and demand.S. Americans knew that $20 .s . but rather were certificates that entitled the holder to get the real money. Because at that point all of the other major currencies were themselves tied to the U.

the u . euros. for the practical reason that it is difficult to dig up more gold . Of course this doesn’t happen in practice because government officials presumably have no interest in wrecking their own economies (though you might not know it from their decisions) .s . and of private individuals to borrow money. the u . and so forth .
The Price of Money Set By Supply and Demand
Whether we have a commodity money such as gold. government and the Federal Reserve don’t have complete control over the quantity of u . with fiat money governments have the ability to increase the amount of money a millionfold in very short order—indeed. pesos. the willingness of commercial banks to grant loans. say. In contrast.6 Despite this
strictly speaking. if everyone used actual gold as the money good. government and its agency. they can do it with a few presses of a button with modern electronic banking . the Federal Reserve. dollar. simply by pressing a few buttons . dollars. But for all practical purposes. Of course with a commodity money. All of the historical examples of hyperinflation—where a money was destroyed because it lost its value so quickly—occurred because governments fell into a vicious cycle where prices kept rising.”
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. or a fiat money such as today’s u . Large and rapid price inflation would be extremely unlikely.Lesson 21: Inflation
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money in the economy .s . plays a role here as well . standard debates over proper “monetary policy” overlook this rather important feature of our world since 1971: the people in charge of their country’s respective currencies literally have the power to destroy them overnight . or the complete contents of its hard drives. wipe out a country’s entire collection of books. the market supply consists of the individual supplies of all the different producers in the private sector . its market price is set by supply and demand . with modern fiat money. Yet this is the current state of our world with respect to perhaps the single most important good: money . governments (or their designated agencies) determine the quantities of dollars. if we include checking account balances as part of the total . control the “dollar supply curve . But most people would not give one or a handful of people the ability to. and so governments kept printing more and more money to pay their bills .s . for example.s . On the other hand.

and so on . suppose we are analyzing the car market for a certain city . dollars .000 and the quantity of cars has doubled to 2. so that the supply curve for cars shifts to the right . For example. An equivalent expression would be to say that the price of a $1 bill was originally 4 gumballs and then fell in half to 2 gumballs . this is all basic review .000th of a car.000 and the equilibrium quantity is 1. that language might strike you as strange at first.000th of a car . If dollar bills and cars were the only goods in the economy. this is a crucial point: When the price (measured
.000 cars . but essentially the car dealer is selling cars in order to buy U. hours of carpentry. but from the point of view of the money? After all.S. His customers are on the other side of the transaction. the same tools of supply and demand can explain the price of ounces of gold as well as the price of rectangular green portraits of Benjamin Franklin . even fiat money is an economic good. the price has dropped to $15. the price of a $1 bill increased to 1/15. now what happens if we analyze this same market. they are selling dollars in order to buy cars . gallons of gasoline. With the original supply and demand. the price of a $1 bill was 1/20. we would be done . suppose that a gumball originally costs 25 cents. that’s the same thing as saying it takes more of a car to buy a dollar bill . but that after the new dealership opened up. However. the one major hitch in using supply and demand analysis in this lesson is that the “price” of money behaves in the opposite way of how you are used to thinking about other prices . We also have to think about how many dollar bills exchange for packs of gum. In terms of the car market. In the new equilibrium. imagine the equilibrium price is $20.000th or 1/15.000th of a car . then there is a new dealership that opens up. For example. In other words.000 vehicles .334
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difference. but then the price doubles to 50 cents for one gumball . so we should be able to use our tools of analysis . the whole point of having money is that it stands on one side of every transaction involving many thousands of different types of goods . we could say that initially. if it takes fewer dollar bills to buy a car. so it’s not really true to say that the price of money is 1/20. so we see that the movement in the price of money was in the opposite direction of the price of the cars . the problem here is when we want to mark the “price” of dollars .

we can also explain what happened in the united states in the mid-1980s . the stock of money (as measured by the statistic M1) grew very quickly even though prices (as measured by the CPI) did not rise nearly as much . and in fact some prices rise while other prices fall . the public became doubtful about the currency’s ability to buy goods and services in the future. the complete collapse of some currencies— where the purchasing power or price of the money fell to virtually zero very quickly—happened when the respective governments began creating incredible amounts of new currency (i . the supply increased) . and so they didn’t want to hold it. from the mid-1980s onward the u . Once we understand the connection between regular prices and the “price” of money. it’s easy to see what causes price inflation: anything that causes the price of money to go down . With this insight. prices of various goods and services do not all rise to the same degree. When the “price of money” falls. the broad explanation of this pattern is simple: the supply of dollars increased but so did the demand. using our standard tools.” economists have devised various “baskets” of goods to provide a rough idea. of which the Consumer Price Index (CPI) is one such measure . hence the demand for the currency began falling . the important point is that you understand that rising prices (measured in money) are the same thing as a falling value or “purchasing power” of money . Once this process began. In other words.e . and/or (2) the demand for money has fallen . it means that the dollar-prices of other goods are going up . we can return to some of the points mentioned earlier in this lesson . that means there can be two causes for a general rise in the prices of goods and services in the economy: (1) the supply of money has increased.Lesson 21: Inflation
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in dollars) of a regular good or service goes up. the process snowballed until the price of the currency was virtually zero. For our purposes. On the other hand. saw a large increase in the quantity of money but a much smaller fall in its price . that’s why it’s very controversial to even define what we mean by “the price of money . economy. that is the same thing as saying the market value of the dollar goes down. and the success in bringing down price
. For example. As the graph earlier in this lesson illustrated.. In the real world.s . the specific reasons for the increase in demand—which probably include the strong u .s . meaning that units of it (such as the German mark) could fetch nothing in the marketplace .

It’s true that it would be very disruptive to the world economy if its money—gold—all of a sudden saw its value fall quite sharply because of the alchemists’ discovery . it would be wonderful if the alchemists made such a discovery. because the market value of money is set by supply and demand . not an unmitigated disaster . but from government-controlled money. and in particular fiat money . for the same reason that historically people never used lead as a commodity money .
7
We should point out that technically. and so sudden increases in supply are beneficial in that respect .
The Danger of Government Price Inflation
Price inflation is not the sole product of government intervention .7 In practice.s . even in a pure market economy using gold. if the medieval alchemists had been successful and figured out a way to turn lead into gold. a market-based commodity money is actually useful for reasons other than its status as a medium of exchange. and have written books and articles describing the mechanics of such a system . the great threat to price stability has come not from market-based commodity money. On the other hand. Besides the fall in prices for beautiful jewelry. as well as the industrial applications . then the market price of gold would have fallen until the returns to alchemists were the same as in other industries . In other words (depending on the exact alchemic process) the price of gold would probably fall until it was close to the price of lead . In theory. consumers would benefit from much cheaper dental work (gold fillings etc .336
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inflation rates from the dangerous levels of the late 1970s—are beyond the scope of our discussion . when the u .8 For example. the “collapse” of the gold money would be a mixed blessing. people in a pure market economy would probably switch to another form of money. the important point is that you cannot look at the number of dollar bills and mechanically calculate what will happen to prices. economists have imagined a fiat money even in a pure market economy. dollar was firmly
even here. however. In this fanciful scenario. a huge influx of gold (from newly discovered mines or from newly discovered foreign lands) can cause the prices of most goods and services (measured in gold ounces) to rise .) and arthritis treatments (which inject gold into the body). because of all the new gold . In the text above we will ignore this complication and assume that fiat money is always the result of government intervention in
8
. unlike a fiat currency.

During arguably the most prosperous decade in u . have constantly risen as the economy moved away from a commodity money (gold) and toward a fiat money .
. nowadays young people must tolerate their parents and grandparents’ boring discussions of how cheap things were “when I was growing up . In other words. but the connection between governments and fiat money is certainly correct in practice .” What these young people—and possibly even their parents and grandparents—don’t realize is that this steady erosion of the dollar is not a fact of nature . eggs. It is the result of the government’s intervention into the economy. there has been a steady and virtually uninterrupted fall in the purchasing power of the dollar . but generally speaking dollars could buy the same amount of goods in one year as they would have in previous decades . history. the harm of persistent price inflation is that it partially defeats the purpose of using money in the first place . and do the same for the salary differences in the two locations . and meat throughout this period.67 an ounce the purchasing power of the dollar was fairly constant over long stretches of time . this is no longer the case . especially since Richard nixon “closed the gold window” in 1971 and formally severed the dollar’s tie to gold. American shoppers did not see significant movements in the prices of milk. and comparing this grand total to the sum of the money prices of the things they sell to their customers . Besides generating boring stories from grandpa. It might fall during a war and rise during an economic crisis. for example.Lesson 21: Inflation
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linked to gold at $20 .s .s . Retired couples who are planning a luxurious european vacation can avoid starving twenty years later by consulting with a financial planner
the market economy . entrepreneurs can tell if they’re running a successful business by adding up the money prices of the inputs they buy. even though the economy was booming . prices of goods and services in the u . Whether this is true even in theory is a controversial issue among economists. through its monopolization of the money stock and its decision to continually pump new dollars into the economy . the CPI was virtually flat from 1922 through 1929 . Remember that the great contribution of having a money is that it helps people make plans and coordinate their activities in the market . by looking at the typical prices of important goods (such as food and housing) in the new area compared to the typical prices in their current location. Workers can make an informed decision about whether to take a new job across the country.

Others expect a surge in prices. but the pace of the increase has been irregular . Having an unsound fiat money is (usually) still better than nothing. to see it another way. is the fact that the drop has been incredibly volatile . then collapsed again during the early years of the Great Depression . In particular. u . dollar—Americans and indeed people all over the world are distracted from building their businesses. comparable to the early period of the Great Depression .9 Because of this uncertainty over a very important aspect of the future—namely the purchasing power of the u . dollar (compared to most goods and services). and doesn’t lose its purchasing power over time—makes all of these activities much more orderly . u .338
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to make sure they’ve set aside enough investments to support them later on . According to steve Hanke. then they collapsed in 1920 and 1921. by november 2008 Zimbabwe was suffering from a monthly price inflation rate of 79 . Prices rose very quickly during World War I. things that cost $1 in the market in 1913 cost about $22 today . someone humorously gave the author of this textbook a “tip” which was a “FIFtY tRILLIOn DOLLARs” note issued by the Reserve Bank of Zimbabwe . At a conference in the spring of 2010.s . the u . playing with their
things became so absurd in Zimbabwe that its central bank eventually issued 100 trillion dollar bills . comparable to (though not as extreme as) the recent case of Zimbabwe . before slowing to much lower growth rates in the 1980s . dollar has lost about 95% of its purchasing power .s . Currently (2010).s . the jokester had acquired this piece of currency—which has a “5” followed by 13 zeroes printed on it—very cheaply on eBay . At this inconceivable rate. prices rose very quickly at the end of the 1970s. but in the extreme governments can render their monies so useless that the public literally abandons the currency and adopts other items as media of exchange . then were steady again through the 1920s.s . One of the official duties of the Federal Reserve—the government-established central bank of the united states—is to maintain price stability . prices have risen steadily.s .6 billion % . prices in Zimbabwe were doubling every 25 hours! (see http://www . Having a sound money—meaning a money for which the value doesn’t bounce around erratically. But beyond this sustained drop in the “price” of the u . investors are divided in their forecasts about future price inflation .cato . since the end of World War II. org/zimbabwe)
9
. some expect a collapse in prices. since the Federal Reserve’s founding in 1913.

) and would buy more financial protection through medical and fire insurance policies . and older workers decide on retirement.Lesson 21: Inflation
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kids. in modern economies sophisticated financial instruments allow investors to protect themselves against price inflation through various means . everybody knows that the u . it is very wasteful . But in terms of the whole economic system. given the poor track record of the Federal Reserve in its official mission of price stability . People wouldn’t sit still and passively accept the new reality. In short. What’s more. When businesses borrow money.
Price Inflation Contained Through Proper Forecasts?
some people pooh pooh the harmful effects of price inflation . they respond and protect themselves using other aspects of the market economy . they will concede that if the rising prices took everyone by surprise. they take this phenomenon into account . this is all true. But the society still ends up poorer compared to the situation where the government left money to the private sector . people in the mixed economy aren’t sitting ducks when the government intervenes in the supply of money . then there would be a problem . some would argue. It’s true that the harm can be mitigated through the market’s defensive reactions .s .
. people could focus on the more important things in life (such as kung fu movies) . and watching kung fu movies because they have to do research on Federal Reserve meetings and constantly tinker with their financial portfolios to include more gold or more bonds . but notice that we could say the same thing if the government randomly injected people with viruses or set their houses on fire . In a pure market economy with a sound money. All of this activity makes sense at an individual level. dollar (and other fiat currencies) will shed their purchasing power over time . etc . more smoke alarms. But by this point. the same principle applies to government price inflation . But it would be nonsense to say that these defensive measures completely neutralized the harmful effects of our hypothetical government virus-injectors and arsonists . instead they would take active countermeasures (vaccines.

under a fiat money system. government monetary inflation must distort the economy relative to the pure market outcome . thus the observed prices might not rise. the government might print up new money and buy goods for which the (private sector) demand had fallen . We have already seen in Lesson 18 that government distorts the economy when it takes resources out of the control of private hands and places them under the discretion of government officials .340
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no matter what.
10
. the government’s newly printed $100 bills are legal tender just as much as the money already in the wallets and purses of average citizens .
Keep in mind that the government’s injection of new money might prop up prices that would otherwise have fallen . this is because the government and central bank invariably use the new money to buy things. etc . as it were . even if a particular episode of monetary inflation doesn’t lead to immediate price inflation. For example. engages in monetary inflation . corporate bonds. no matter what the public does in response.10 the government intervention still distorts the economy relative to the pure market outcome . In this case.) when the government controls the printing press . it cannot prevent the government from siphoning away actual goods and assets (barrels of oil. the monetary inflation still causes price inflation. For this reason. but it would be wrong to conclude that the monetary inflation had no effect on prices . i . whether tangible goods (like tanks and bombers during a war) or financial assets (like a mortgage-backed security in the wake of the 2008 financial panic) . this harmful process necessarily occurs whenever the government creates new money..e . but from a lower starting point.

. versus digging up more gold and silver. • Large-scale and persistent price inflation can devastate an economy. All major governments have used various means to force their people to stop using market-based commodity monies (such as gold and silver) and to instead use paper fiat currencies. people have less incentive to save and make long-term investment decisions. Without a sound currency. as measured in units of money. • Government intervention leads to systematic inflation. Price inflation refers to a general increase in the prices of goods and services. it limits the benefits of having a money in the first place and pushes society back towards a situation of barter. in our economy the term refers to an increase in the total number of dollars. When money’s purchasing power erodes quickly and erratically. It is much easier to expand the amount of fiat money.Lesson 21: Inflation
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Lesson Recap •••
• Monetary inflation refers to the expansion of money.

this is why M1 indicates more total money than just the amount of paper currency . (Because of the fractional reserve banking system. the CPI is an average (weighted by their relative importance) of the prices of gasoline. quoted in units money . but nowadays tends to refer to price inflation . Price inflation: A general increase in the prices of goods and services. and cashiers’ drawers) but also the total amount of checking account balances . If everyone tried to withdraw his or her checking account from the banks at the same time. Price inflation is the same thing as a fall in the purchasing power of money . Monetary inflation: An expansion in the total amount of money in the economy . M1: A popular measure of the total amount of money in an economy . purses. there wouldn’t be enough currency to go around . food.)
. Consumer Price Index (CPI): the Bureau of Labor statistics’ gauge of the “price level” affecting regular households . Stock of money: the total amount of money in the economy at a particular time .342
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new Terms
Inflation: A term that originally referred to monetary inflation. M1 includes the actual currency held by the public (in their wallets. and other common items . M1 is larger than the number of dollars printed on green pieces of paper .

there is no precise boundary between inflation and hyperinflation. is that they expect it to have purchasing power in the future . founded in 1913 .
. When coins were valued because of their precious metal content.s . but in a hyperinflation people begin buying anything at all in order to unload their money holdings which are losing value by the hour . the “Fed” is responsible for u . the only reason people accept fiat money in trade. Fiat money: Paper money that is not “backed” by anything .Lesson 21: Inflation
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Hyperinflation: Very severe inflation . under fiat money. debasement meant melting the coins and re-minting them with baser (less valuable) metals added to the mixture . and has the dual mandate of providing stable economic growth (which implies full employment) and low price inflation . Debasement: Government policies that weaken the money . monetary policy. which reduces the value of a single unit of money . debasement involves the rapid creation of new money. Federal Reserve: the central bank of the united states.

What are the two meanings of the term inflation? 2. What is the harm of government price inflation?
. If the stock of money increases. Why do workers sell their labor hours in exchange for intrinsically useless pieces of fiat money? 4.344
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sTudy QuesTions
1. what happens to the “price of money.” other things equal? What does this imply for the prices of goods and services? 5. Is there a strict connection between money growth and price increases? 3.

• How government debt makes future generations poorer. so too for the government . Just as a private company can sometimes have periods where its expenses are higher than its revenues. it runs a budget deficit . • The connection between government debt and inflation.A d vA n c e d L e s s o n 2 2
Government Debt
In this lesson you will learn:
• The difference between government deficits and debt. Fiscal Year 1990 ran from
1
L
345
. which do not coincide with calendar years . etc . this sentence only tells us about the federal government’s finances in
the finances of the u . “the u . federal government are usually recorded by fiscal years. In any particular budget period. the government takes in revenues which it uses to pay its expenses .”1 strictly speaking. fees for the use of public parks. the military. the government may want to spend more total money on social programs. When the government spends more than it takes in. a critic of Ronald Reagan might say. For example. government deficits are measured on an annual basis .
Government Deficits and Debt
ike a private company.s . For example. and so forth than the government has collected in taxes. rising from about $74 billion in 1980 to $221 billion in 1990 . federal budget deficit almost tripled during the 1980s. In most financial reports and commentary.s .

in which the expected payouts will at some point exceed the “contributions” from workers and will thus constitute a drain on general tax revenue.2 the debt is a stock variable meaning that its value is defined at any point in time .346
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two different years. For example. the government debt refers to the total amount of money that the government owes to other organizations or individuals .000 in his first ten years in the major leagues . contributing to the government’s overall indebtedness . our reporter’s sentence is confusing . a smaller figure of the debt might refer exclusively to the actual bonds issued by the u . the budget deficit in 1980 was the difference between receipts and expenditures in that year. which would make the “federal debt” greater or smaller . “How much has the government spent between the start point and Monday at noon. A much broader figure would include not just the bonds. 1989 through september 30. the $221 billion deficit thus refers to the mismatch between federal receipts and expenditures during these two dates . but also the federal government’s expected future liabilities in programs such as social security. it will add $100 billion to the deficit over the next ten years . it is a flow variable that happens over a period (such as one year) . “What was the federal budget deficit as of Monday at noon?” unless you implicitly had a previous starting point in mind. “Because the new health reform legislation will raise federal spending by $900 billion while increasing taxes by only $800 billion. In contrast. the government deficit measures the difference between spending and receipts during a particular slice of time. sometimes reporters use sloppy language when reporting on a new government program . For example. versus how much has it collected in taxes during the same period?”
October 1. For example they might say.
2
.s . it makes sense to ask.” But since most people use deficit to mean a single-year mismatch between receipts and spending. It would be as if a baseball announcer said that the big hitter at the plate had a batting average of 3. there are different items that could be included in this figure. “What was the total government debt as of Monday at noon?” But it wouldn’t make sense to ask. treasury . so that you were really asking. and the deficit in 1990 was the gap ten years later . 1990 .

and interest payments .05 = $10. (But for bonds that carry no coupon payments.524 x 1 . it borrows money from lenders by having the treasury sell bonds . By walking through the table you will have a much better understanding of government deficits.000 (roughly) .Advanced Lesson 22: Government Debt
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When the government runs a deficit. leaving less money available for other government programs . For example. If the government (or another entity) issues long-term debt. When the federal government runs a deficit.5 When people talk of the enormous national debt—by which they almost always mean the u . the lender hands over the full face amount of the bond upfront.524 for it. he earns a return of 5% on his money. federal government promising to pay him $10.000 in exactly one year. because $9. federal government’s debt—they might complain that interest payments are one of the largest spending categories.s .
the u .)
4
If interest rates fall then the government could enjoy lower interest payments even as its debt grows .s . because the interest earnings are handled separately . if an investor buys an IOu from the u . it covers the shortfall just as a corporation can: it issues debt. As the federal budget deficit grows. it will often involve periodic interest payments (“coupons”) . debt. which apply to treasury debt that is one year or shorter in maturity . but the investor only has to pay (roughly) $9.s . the table on page 348 illustrates a hypothetical government’s finances for a three-year period .
3
In the text we are restricting our attention to “zero coupon” bonds.
5
. the interest payments to service that debt (typically) grow as well . it must pay them interest . treasury is the financial arm of the federal government . In this case. meaning that the government sells treasury bonds to outside investors .4 with the difference giving rise to the implicit interest return (or yield) on the bond .3
Interest on the “National Debt”
When the government borrows money from lenders by selling them government bonds. the treasury collects taxes and disburses funds . specifically what happens is that the investors pay less for the bond than the face value. the investor must earn his interest through a discount initially paid for the bond .

even if the government balances its budget in a particular year. part of its tax revenues must go to paying interest on the debt . the other $100 billion is simply rolled over by reissuing the same amount of debt in new one-year bonds .Advanced Lesson 22: Government Debt
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• In any given year (each vertical column). When that event is still in the future. However. the outstanding government debt is simply the present market value of the government bonds held by the public . • At any given time. the budget is balanced . there is a deficit . the government’s debt always consists entirely in oneyear bonds . the expenditures always equal the sum of that year’s spending on Military. even though technically it must pay out a grand total of $1 . social programs. • When the government carries a debt. • The government debt changes during the course of the year based on that year’s surplus or deficit . the Tax Revenue is $1 trillion while the expenditures vary . Of the $105 billion that the government must pay to the bondholders (who purchased bonds in 2010). because the government is not obligated to pay the full face value until the actual time of maturity . the government’s contractual obligation is discounted by the interest rate (5% in our example) .1 trillion while tax revenues are only $1 trillion . In the table this happens in the year 2011 . there is a Surplus . this number is lower than the summation of the face value of all the outstanding bonds.
In our example. it has less money available for the military and social programs if it is carrying a debt from earlier years . If they are equal. only $5 billion is considered a government expense—namely an interest expense—for the year 2011 . and Interest on the debt . In the real world the government spreads its debt among bonds
. the government has a balanced budget. • If Tax Revenue is higher than Expenditures. If revenues are lower. • It is not counted as an expense of government when it simply reissues or rolls over debt that is maturing .

this allows the government to plan its finances more accurately by “locking in” interest rates for longer than one year when it borrows money . federal debt and the CPI:
Consumer Price Index for All Urban Consumers: All Items (CPIAUCNS) Gross Federal Debt Held by the Public (FYGFDPUB)
220 200 180 160 140 120 100 80 60 40 20 0
1946 1956 1966 1976 1986 1996 2006 2016
6. 5-years.107 3. recessions 2010 research .org
CPIAUCNS (Left) PYGFDPUB (Right)
Yet even though there is apparently a general connection between government debt and rising prices. 6-months.” there is certainly an element of truth to this popular association.s .708
(Index 1982–84 = 100)
shaded aeas indicate u . “this will hurt the dollar and cause [price] inflation .304 1. the first important point is that a
.) . Whenever the u .511 5.stlouisfed .703 1. it’s important to use sound economic theory to understand why this should occur . government runs a particularly high budget deficit.
Government Debt and Inflation
It is very common among the lay public and even sophisticated financial analysts to associate government debt with rising prices . etc .309 4.102 501 -100 (Billions of Dollars) 4. 1-year. for example.910 5. many people will say.506 2.s . and there is also a decent (though far from tight) historical correlation between the u .905 2.s . 3-months.350
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of varying maturities (1-month.

dollars .
6
. it does not create new money in the economy . In the first place. it would be harder for the government to service its debt compared to the expected scenario . the government in principle could borrow the remaining
It’s true that investors will take this dynamic into account when lending money to the government.s . it turns to the printing press . In this narrow respect. government bonds are very liquid (marketable) financial assets. then it can only raise so much more through borrowing .s .6 the more basic connection between government debt and inflation is simple: When the government wants to spend an incredible amount of money—such as during a world war—it can only raise so much through taxes . suppose the government wants to spend $6 trillion. it makes it easier for the federal government to service its pre-existing debt . u . At that point. On the contrary. a federal budget deficit is no more inflationary than a private corporation’s decision to borrow money from the public . In practice. especially long-term debt that was originally issued many years earlier . it is still true that when the Federal Reserve causes inflation. dollars—they are not money . they will insist on a higher yield (interest rate) knowing that the purchasing power of the dollar will likely fall over time . When the government runs a deficit and borrows money by issuing new bonds. it means that other people in the economy have that much less money in their possession . in exchange for IOus issued by the treasury . this makes it easier to afford the fixed dollar payments on debt. but they are not the same thing as u . and therefore should not have any direct influence on the prices of goods and services in the united states . All we have really established is that by itself a government budget deficit doesn’t create new dollars. By raising prices throughout the economy—including wages and salaries—through the creation of new dollars. even so. government budget deficits provide a strong incentive for the Federal Reserve to create more u . If the Federal Reserve were to suddenly stop inflating altogether.s . they hand $200 billion in money to the government. however. and only has tax revenues of $2 trillion . price inflation tends to lighten the “real” burden of debt . if the government still wants to spend more money. But there is more to the story . the Federal Reserve can indirectly boost tax revenues for the federal government .Advanced Lesson 22: Government Debt
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government budget deficit by itself is NOT inflationary . if the government runs a deficit of (say) $200 billion.

after the Federal Reserve pays it electric bill. and because the
7
. However. then. because the federal government still owes interest and the return of principal to the holder of the bonds it issued . but investors would become nervous at such a large sum and might demand a much higher than normal interest rate . the government’s
If you are a sharp reader you might think that this isn’t truly printing up new money just to close a budget shortfall. while the private bond dealers are back to their original position (plus a little money for commissions on the trades) . what happens in the grand scheme is that the Federal Reserve creates new dollars and lends them to the treasury. because the Federal Reserve quickly steps in and buys the newly-issued treasury bonds from the private dealers . But guess what? the Federal Reserve is the recipient of these payments (since the Federal Reserve bought the bonds from the private dealers). the Federal Reserve pays for the bonds not out of its past savings. and so forth.7 so although the process is convoluted. the treasury issues enough new debt to buyers in the private sector to completely cover the official budget deficit .e . the government would be employing its position as the money monopolist in the exact same way that a private sector counterfeiter behaves . it goes through a very complicated process: First. the private bond dealers are happy to oblige the treasury with very low interest rates on these massive loans. Instead. if the government wants to use its control of the printing press to help cover a deficit.. it sends back to the treasury . any extra money it has. which then spends them on its various programs . but rather through creating new dollars out of thin air . the government actually doesn’t behave this blatantly . Furthermore. employees. now in the united states financial system. In other words. the private bond dealers). the government might only borrow $1 trillion. the Federal Reserve ends up holding the new treasury bonds on its books. the public might balk at such a huge deficit (as a fraction of the total budget) and insist that the government slash its spending . and then literally create the extra $3 trillion in new money. for all practical purposes it did. in order to pay its bills . so even though technically speaking the treasury didn’t get those new dollars with no strings attached. In this pickle. When all is said and done. If we step back and ignore the middlemen (i .352
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$4 trillion. since its interest payments on the debt held by the Federal Reserve will (largely) come right back to the treasury. and as standard operating procedure the Federal Reserve remits all of its excess earnings back to the treasury .

it doesn’t matter whether the expenditure is financed through tax hikes or borrowing .C . politicians have done and continue to do . there is no time machine by which people today can steal pizzas and DVDs out of the hands of people 50 years in the future . in practice there is a difference in how this burden is shared among the present generation. and that’s the whole reason that it’s popular to run budget deficits . the answer is nuanced: Yes government deficits do impoverish future generations.
. opponents of government deficits often claim that they represent theft from unborn generations . it is the present generation (collectively) who pays for it . When thinking about any debt. For an analogy. now of course.
Government Debt and Future Generations
In popular discussions. which is exactly what the D . Is this typical claim really right? As with the popular association of government debt and inflation. If the government spends an extra $100 billion to mail every voter a lump sum payment to go spend at the mall. and if you knew you never had to pay back the principal. then the process of signing a loan contract with them would be a farce . be it government or private. keep in mind that all goods are produced out of present resources . You would spend with reckless abandon. then the present generation has gotten to enjoy an extra $100 billion whereas future taxpayers will have to bear the cost .Advanced Lesson 22: Government Debt
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control of the monetary and banking systems gives it the option of creating new dollars in order to close a budget shortfall . but no they don’t do so for the superficial reason that most people believe . either way. and if you knew your parents would always increase your birthday and Christmas gifts to give you all the “interest payments” on these loans right back to you. this is one important mechanism through which government deficits can lead to monetary inflation and ultimately higher prices . the idea is that if the government spends an extra $100 billion to make voters happy but without “paying for it” through raising taxes. if you could always borrow money from your parents (at a contractual interest rate) when you spent more than your job’s paycheck. If the government raised everyone’s taxes in order
Federal Reserve will likely roll over the principal on its outstanding holdings of treasury debt .

they’re not . the average voter feels richer .s . people
9
. But by the same token. because rational taxpayers will realize that they need to set aside more money to pay for future debt service . so here are two main reasons that government deficits make the country poorer in the long run:
• Crowding out. the critics are right: Government deficits do make future generations poorer . and “future generations” to mean all future humans. since (as we just explained) those interest payments go right into the pockets of people in the future generations . these economists say that when the government shifts out the demand for loanable funds. then we’re back to the analysis in the text above .
8
some economists would argue that in the grand scheme. which entitle them to streams of interest and principal payments . higher deficits today mean that future Americans will inherit more financial assets (those very same government bonds!) from their parents. When the government runs a budget deficit. present Americans would indeed be living above their means and in the process force future Americans to live below their means . government deficits are largely irrelevant. But if instead the government borrows $100 billion from a small group of investors and then mails this money out to everybody else. which causes some people to save more (moving along the supply curve of loanable funds) but also means that other borrowers end up with less . mean that future Americans will suffer higher taxes (necessary to service and pay off the new government bonds) .354
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to send them all the money back in a check. But if we take “the present generation” to mean all humans. It is certainly true that higher government deficits today.9 In effect.8 so what does all this mean? Are massive government deficits really just a wash? no. that would be pointless . government’s debt . the total demand for loanable funds shifts to the right . In that case. the government competes with
things get more complicated if we consider that foreign investors might be the ones financing the u . But the reasons are subtler than the obvious fact that higher debts today lead to higher interest payments in the future. In other words. One way to see the fallacy in the standard “we’re living at the expense of our children” analysis is to realize that today’s investors bequeath their government bonds to their children . this pushes up the market interest rate.

etc . Recall our thought experiment from Lesson 18: If the government enacted ridiculously high income and sales tax rates. and this action would cause dislocations to the economy over and above the simple extraction of revenue . and goes into the pockets of the people who inherited the government bonds . Rather. it borrows back from them with its left hand . • Government transfers are a negative-sum game. and needs to pay back $100 billion to creditors in 30 years. that does indeed make the country poorer at that time . At the higher interest rate. economists say the government borrowing crowds out private investment . and what the government hands out to taxpayers with its right hand.Advanced Lesson 22: Government Debt
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other potential borrowers for the scarce funds available . But clearly these policies would be very harmful to the economy. Another way that government debt makes future generations poorer is through the harmful incentive effects of the future taxes needed to service the debt . thus the market interest rate stays the same. the government would probably raise taxes (rather than cut its spending). this principle explains how the true damage of an extra $100 billion in taxes (needed to pay down the government
10
. But the problem is not the $100 billion payment per se—that comes out of the pockets of taxpayers. For example. entrepreneurs invest fewer resources into making new factories. buying more equipment. less equipment. despite the apparently low “burden” as measured by tax receipts . However. so long as we make the very plausible assumption that the government will not use the borrowed money as productively as private borrowers would have. it means that future generations inherit an economy with fewer factories. in practice this view can’t be right.10
in the private sector rationally respond by shifting out the supply curve as well . and so on . the problem is that in order to raise the $100 billion. virtually all economic activity would go underground and the government would take in virtually no tax revenue . This is a major factor in explaining why government deficits translate into a poorer future . because otherwise deficit spending wouldn’t be as popular as it is . if the government runs a deficit today.

that would be a cure worse than the disease . but the mechanisms are subtler than the simple increase in the amount of money the federal government owes to various creditors . Recall from Lesson 18 that all government spending. Yet another danger of government deficits is that they tempt the government into spending more than it otherwise would . the possibility of issuing government bonds leads to higher government spending (and hence more resource misallocation. compared to the pure market outcome) than would occur if the government were forced to always run a balanced budget . the way to alleviate these problems of deficits is to cut spending. then it would be no “solution” to close a budget deficit through tax hikes in the present . no matter how it is financed. Because the public typically resists new government spending less vigorously when it is paid for through higher deficits.
so we see that government deficits really do make everyone poorer (on average). But as the bullet points above indicate.356
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• The option of borrowing leads to higher spending.
debt) is greater than the simple extraction of that amount of money from taxpayers . and make it more likely that the government will hike tax rates in the future. siphons scarce resources away from entrepreneurs and directs them into channels picked by government officials . not to raise taxes on the present generation! In other words. if the real problems of government deficits are that they take resources out of the present capital markets.
.

. and result in a smaller inheritance for future generations. government deficits divert real resources away from private-sector investment. a practice that is inflationary. If the government borrows $50 billion to build tanks today. • Government deficits do not impoverish future generations in the simple way that many people believe. However.) are provided by the present generation. those resources (steel. in a very subtle process. labor hours. • Government deficits by themselves do not create new money. 2010). In that respect today’s deficits make future generations poorer than they otherwise would be. and do not directly contribute to rising prices.Advanced Lesson 22: Government Debt
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Lesson Recap •••
• A government budget deficit is the amount by which it spends more than it collects in tax receipts over the course of a certain period (such as the year 2010). etc. The overall debt is the total amount the government owes lenders at a certain time (such as May 14. computer chips. they are not “paid for by our grandchildren” through a time machine. government deficits allow the Federal Reserve to purchase more Treasury bonds. The debt is the cumulative result of all previous deficits and surpluses. However.

this figure for the u . 2010 could be 150 pounds . As of May 2010.358
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new Terms
Flow variable: A concept that is measured over a period of time .gov/ govt/reports/pd/mspd/2010/opds052010 .treasurydirect . Face value of a bond: the amount of money the bond issuer promises to pay to the holder of the bond at the maturity date . private-sector businesses borrow less to fund investment spending .pdf) Crowding out: the reduction in private-sector investment that results from government deficit spending . National debt / public debt: usually refers to the total outstanding value of bonds issued by the u . but instead would refer to his weight at that very moment .
. they usually net out the “intragovernmental holdings” and report only the government debt held by the public.s . but much of this consists of treasury bonds held by other government agencies (such as the social security Administration’s “trust fund”) .m . but instead would refer to how many gallons passed through a particular section of the pipe every 60 seconds . this measurement wouldn’t refer to the total amount of gallons contained in the entire pipe. Stock variable: A concept that is measured at a specific point in time . on May 11. the flow rate of an irrigation pipe could be 100 gallons per minute . As of May 2010. When economists compare the levels of debt owed by various governments. treasury .s . For example. this measurement wouldn’t refer to the number of pounds the man had recently gained or lost. treasury was almost $8 . which makes the equilibrium interest rate higher than it otherwise would be . At the higher interest rate.5 trillion . For example. the government’s borrowing increases the demand for loanable funds. (see http://www . the “public debt” was almost $13 trillion. a man’s weight at 9 a .

even if the budget is in surplus? 4. what can we say about the budget? 3. When the government spends more than it collects in tax revenues. *Does it help future generations by raising taxes now to close a budget deficit?
. *Explain: “The government deficit is a flow variable. *Is it possible for the government to sell new bonds in a given year. Are government budget deficits directly inflationary? 5.” 2. while the debt is a stock variable.Advanced Lesson 22: Government Debt
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sTudy QuesTions
1.

.

• The causes of mass unemployment. also known as the boom-bust cycle. for some reason the economy always starts to sputter. business sales and wages plummet. eventually giving in to a downturn in which workers lose their jobs. through which the alleged extremes of the market can be tamed . However. For example. beyond
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. and the stock market falls or even crashes .
Most people. the stock market soars. it is very popular for the government to engage in countercyclical policies. businesses expand and hire workers. • How government intervention causes the business cycle. many analysts would say that social welfare programs and progressive income taxes. believe that business cycles are an inherent property of the pure-market economy . On the upswing of the business cycle.
The Business Cycle
T
he business cycle. refers to the periodic rhythm that seems to plague market economies . and there is a general feeling of euphoria . Indeed because of this widespread perception. for some reason the people living in capitalistic economies experience alternating stages of prosperity and recession . wages and prices rise.A d vA n c e d L e s s o n 2 3
The Business Cycle
In this lesson you will learn:
• The typical elements of the business cycle. including even many fans of capitalism. Rather than enjoying uninterrupted growth.

namely that the government (and Federal Reserve) should use their various powers to navigate the economy through the choppy waters of prosperity and recession .2 the government causes a period of false prosperity when it artificially pushes down interest rates below their
In this common analogy. people are pushed into higher tax brackets (because of rising incomes) and thus the government takes in extra revenue. which helps build up a cushion for the down times. but instead government intervention. the economy is likened to an engine. which in turn hurts business sales even further. In this popular view. During the boom period. and so on . In this way—according to the popular understanding—the slump in business activity doesn’t fall into a vicious downward spiral. and also helps “cool off” an “overheated” economy .
. government programs such as unemployment benefits and food stamps automatically kick in to provide needed income to people who have lost their jobs . the concept of countercyclical policies reflects one of the guiding themes in conventional discussions of economic policy. where “overheating” means high price inflation and apparently irrational increases in stock prices and other assets . we are here presenting the basics of the so-called “Austrian business cycle theory.362
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their other possible merits. the goal or duty of the government and Federal Reserve is to give citizens a steady and smooth increase in living standards. also serve to “dampen” the ups and downs of the unregulated business cycle . drug gang violence. you should be skeptical of these typical claims of the ability of government intervention to “fix” things in the economy .
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2 If you are curious in reading further. We have already seen several examples where it was not the free market. when it comes to macroeconomics—which is the study of the whole economy.” developed by economist Ludwig von Mises and elaborated by Friedrich Hayek . where one round of layoffs leads to less money for consumers to spend. without the wild swings that would allegedly occur in a purely free market . By this point in the book. that caused certain social problems— these included slumlords. rather than individual product or labor markets—there is an alternative viewpoint that blames business cycles on government intervention . According to this school of thought.1 then when the bust occurs. Indeed. and apartment shortages in big cities .

In this setting it is also possible for people to cut back on their present consumption. If the theory presented in the following pages is correct. in order to save and
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How Governments Cause the Business Cycle
In order to understand how government intervention could possibly be the cause of the familiar ups-and-downs of the business cycle. all alone on his tropical island. Market-Driven Economic Growth
In Lesson 4 we explained how poor Robinson Crusoe. so that he could enjoy more coconuts. and at some point the economic house of cards collapses. shelter. fish. We have saved this discussion for the final lesson because it will draw on several concepts from earlier lessons . Although some of the remaining material may be a bit too advanced for you. compared to his situation when he first landed on the island . Crusoe could build up a stockpile so that eventually he could begin investing his time and other island resources into building capital goods such as a long pole . In Lesson 10 we took these basic insights about Crusoe’s world and applied them to a modern market economy . and leisure. it means that governments not only create business cycles.
Sustainable. let’s first review what happens in a pure market economy when consumers decide to increase their saving . could improve his standard of living through discipline and foresight .” In an introductory book we can only provide you a sketch of this explanation for business cycles . leading to all of the things we associate with “recession . but that the “medicine” they give during the recession phase is actually poison . With the pole and other capital goods. By saving (rather than consuming) some of the coconuts he collected with his bare hands every day.Advanced Lesson 23: The Business Cycle
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proper free-market levels . we urge you to digest as much as possible because it is crucial for citizens to understand the causes of the business cycle . Crusoe’s labor would be vastly augmented in the future. But the illusion cannot last forever.

is to enjoy a greater amount of consumer goods . there is a short-term tradeoff in which consumption actually drops in the present. What actually happens in a sustainable. As the market interest rate falls. then restaurants will have to lay off waiters and waitresses. the crucial thing to remember is that in a sustainable. the longerterm projects are penalized less and less. namely those industries that are growing because of the lower interest rate . of course. these workers and other resources are then “freed up” to be absorbed into the expanding sectors. and some of the factories producing DVDs may have to shut down . this is because a given investment project— which has a certain number of years of money “going in” before the finished product can be sold and money can be “taken out”—will seem more or less profitable depending on the interest rates used to evaluate the timing of its expenses and revenues . market-driven expansion—where the interest rate falls because people are consuming less and saving more—the extra resources flowing into the new investment projects are coming from the sectors which are seeing a drop in sales . and entrepreneurs are given the green light to hire workers and buy raw materials to begin these projects . in order to contribute more to their savings accounts every month. as it were. For example. But because of scarcity. but rather on pole construction .364
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invest which allows them to enjoy a permanently higher standard of living in the future . in order to fund the construction
In terms of diagrams. the supply curve of loanable funds shifts to the right.
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. Recall the specific role that interest rates play in this process: When most people in the economy decide that they want to cut down their present spending in order to provide for their retirement (or to provide a bigger inheritance for their heirs). market-driven expansion is that workers and other resources are redeployed away from present consumption goods and into capital goods . their decision causes interest rates to fall . if consumers are cutting back on restaurant dining and purchases of DVDs. It is the analog of Crusoe devoting some of his labor hours not on coconut gathering. pushing down the equilibrium interest rate .3 the lower interest rates provide a signal for entrepreneurs to borrow more and invest in longer-term projects . In both cases the ultimate objective.

there is no magical way to increase the productivity of labor so that everyone can consume more immediately and permanently . the central bank (the Federal Reserve in the united states) pushes down interest rates below their free-market level . In effect. Government-Driven Economic Growth
now let’s suppose that government officials do not have the patience that sustainable economic growth requires. but for our purposes you can simply imagine that it prints up new $100 bills and enters the loan market.
P s1 6%
(Fed Inflation)
s2
4% D Q1 Q2 Q
Market for Loanable Funds
. but it’s important to remember that sustainable prosperity and economic growth rely on discipline and patience . they want the benefits of more investment without the pain of higher saving (i . reduced consumption) . the specific mechanism that the Federal Reserve uses is rather technical. to this end. offering to lend the new money at lower interest rates than the prevailing market rate .
Unsustainable.e . Absent a new technological invention. or the discovery of new supplies of natural resources.. eventually this abstinence more than pays for itself. the Federal Reserve becomes a new supplier of loanable funds (which come from the printing press).Advanced Lesson 23: The Business Cycle
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of more capital goods . and moves the supply curve to the right .

entrepreneurs are given the green light to start longer-term projects . It is physically impossible for the economy to produce more tractors and more television sets with the same amount of workers. At the lower interest rate. which further contributes to the general feeling of prosperity . However. therefore what the entrepreneurs in one part of the economy are trying to do with resources. In other words. all it did was print up green pieces of paper and hand them out to entrepreneurs . Remember that one of the functions of free-market prices is that they provide signals which help coordinate economic activity . the government didn’t come up with a new scientific formula or stumble upon an unknown oil field. unlike the market-driven expansion. It therefore seems that every sector is enjoying growth . this action by itself doesn’t alter the underlying facts of scarcity . in the government-driven version there is no corresponding drop in consumer spending on restaurants. so are the consumer sectors . and equipment . What’s going on? the answer is that the government’s distortion of the interest rate has misled entrepreneurs . but which now make sense given the “cheap credit” supplied by the Federal Reserve . Yet in the government-driven expansion. because at the lower interest rate. But we know that this perception of euphoria must be an illusion . the competition to hire new workers leads to increasing wage rates. does not mesh with what
. initially it seems as if the economy can have its cake and eat it too—that it can produce more capital goods and more consumer goods.366
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superficially. On the contrary. without any waiting period . people have less of an incentive to save and so they spend more on present enjoyments . these businesses are enjoying an increase in sales. they hire workers and buy raw materials for enterprises that appeared unprofitable at the original market interest rate. while the entrepreneurs who make capital goods are seeing their businesses boom. and other retail sectors . the results of this operation resemble a market-driven expansion . consumers had to cut back on television sets (and other consumer goods) in order to allow for more tractors . raw materials. In a market-driven expansion. By making it artificially cheap to borrow capital funds. the government has (loosely speaking) fooled investors into behaving as if there were more savings than actually exist . DVDs.

Yet in a few months. even though the economy as a whole is not investing enough in its capital structure to offset depreciation . the
strictly speaking. the producers of many types of capital goods can see their output increase. After all. if nAsA builds a rocket using false “laws” of physics or engineering.Advanced Lesson 23: The Business Cycle
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entrepreneurs in other parts are trying to do. the tradeoff can be temporarily postponed if entrepreneurs ignore the wearing out of the existing capital stock. and no one’s plans match up with how consumers expect to spend their paychecks . Regular usage results in depreciation. But when it comes to the false prosperity of a government-induced boom. a factory owner may defer his normal practice of stopping production every month in order to lubricate the machinery etc .. the factory owner would have thought he was increasing his wealth and hence his “stock of capital. During the artificial and unsustainable boom. In order to make anything—whether a consumer or a capital good— entrepreneurs must use existing tools and equipment . However. he still must periodically attend to maintenance on his pole. even after Robinson Crusoe’s initial saving and investment have paid off. drill presses. You might think that such confusion and divorce from the actual economic facts would immediately reveal itself . this delayed reaction is made possible by capital consumption . iPods. For example. In other words.
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. “total investment” is a subtle concept that requires market prices to be calculated . he finds to his shock that equipment prices have skyrocketed . when his equipment is worn down from the hard usage and he needs to buy replacement units. it can sometimes take years before reality rears its head .” but in reality he was consuming capital because his increased output of capital goods (the product of his factory) wasn’t enough to offset his failure to engage in maintenance on his equipment . since the printing press doesn’t give society the ability to create more goods and services . or to the gradual construction of a new pole to replace the old one when it becomes too tattered . then total investment—correctly measured—must drop. bicycles) simultaneously—at least for a while . it actually is possible for the economy to suddenly produce more capital goods4 (tractors. because “on paper” he is making more profits by cranking out orders for his customers . the wearing away or using up of these items . if the false boom allows for an increase in consumption. they realize their mistake pretty quickly . up until that point. two-by-fours) and more consumer goods (tVs.

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same is true for a modern market economy . say. now you should be able to understand the general outlines of how a false. As the boom progresses. through “eating the seedcorn” and not plowing enough resources back into maintaining the existing economic structure . In the first place. and (2) rising prices . this cause-and-effect relationship still holds. When the central bank (the Federal Reserve in the united states) creates new money in order to increase the supply of loanable funds. Recall that in Lesson 21 we learned that monetary inflation (other things equal) causes price inflation . government-driven expansion or boom is at least possible . the charade can continue for years. and are increasing the value of their enterprises . there are two major distortions: (1) An artificial boom created by the lower interest rate which (falsely) signals an increased availability of savings. with everyone seeming to enjoy a higher standard of living. at least some output every year must go toward replacing the capital goods used up in that year’s production . But once the bust occurs. everyone will realize that they behaved foolishly during the boom period . a simple oneshot injection of new money—a burst of. $1 billion over the course of a week—would quickly work its way through the loan market and into the broader economy .
The Inevitable Bust Following an Artificial Boom
In the typical business cycle. In order to keep the interest rate below the free-market level.
. but only temporarily . the false prices (caused by printing up new money and injecting it into the financial markets) can mislead entrepreneurs. regardless of the purpose for the new money creation . In order to simply maintain the current standard of living. Interest rates would drop. if it wishes to keep the “stimulus” going . so that they unwittingly begin longterm projects for which there are not enough actual savings . the central bank generally has to continue pumping ever increasing amounts of new money into the loan market. and market prices quickly change to more realistic numbers. Of course the vast majority of people don’t realize this is occurring—on paper the businesspeople are making record profits. the period of (apparent) prosperity tapers off once rising price inflation causes the central bank to raise interest rates . the central bank needs to continually feed in new money .

more and more analysts and even the general public begin to question the central bank’s “easy money” and “cheap credit” policies . because entrepreneurs would adjust to the new condition and largely offset its impacts in their calculations . grandiose projects that clearly should never have been started . For all these reasons. to be incorporated into businesses that were not so completely taken in by the false reality of the boom period . Finally and perhaps most significant. As the price inflation becomes progressively higher. and are overseeing half-finished. Other businesses can afford to stay in business. many entrepreneurs realize they have behaved foolishly. and sell their equipment and inventory off to the highest bidders. the central bank typically needs to pump in ever increasing amounts of new money. these entrepreneurs do what they can to salvage a bad situation . As market prices become more accurate.
The Causes of Mass Unemployment
the single most significant aspect of the business cycle—in both political and human terms—is the mass unemployment that occurs during the bust or recession phase .Advanced Lesson 23: The Business Cycle
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However. but eventually showing up in prices at the grocery store . some need to shut down immediately. there is also the obvious fact that a given dollar amount—for example $1 billion a week in newly injected money—would have less and less impact. At some point. as the “real” problems of the unsustainable expansion began to appear. Yet ironically—and perversely—the very government policies that most people recommend to “help” the plight of the
. closer to their true free-market level . Interest rates begin to rise. therefore—and perhaps several years after the start of the monetary expansion—the central bank chickens out and at least slows the injection of new money into the loanable funds market . even a continuous yet stable stream of new money might quickly lose its ability to fuel an economic boom. but they suffer large losses and experience a period of belt-tightening . perhaps first hitting financial and commodity markets. as the money stock grew over time . But this eventually leads to worrying spikes in various prices. ever greater amounts of monetary inflation would be necessary to hide the growing imbalances in the structure of production . the longer it wants to sustain the apparent economic prosperity . lay off all their workers.

But the mere printing up of new money hasn’t actually created more workers or other resources to go around . When the boom collapses and turns into a bust. the artificial prosperity of the boom period was fueled by the government’s interventions pushing down the interest rate . then it is physically impossible for them all to reach completion . but for which (in light of the new information) there won’t be enough car buyers to support its operations. the “false” price of borrowing credit led entrepreneurs to borrow more than there was true savings available . it absorbs resources that could have been used elsewhere . it must go something like this: those resources that were drawn into unprofitable projects or sectors during the boom period. too many of these long-term projects are started. Remember from Lesson 12 that the pure market interest rate serves to ration the available savings among all the competing borrowers. because then the entrepreneurs catch their mistakes sooner and stop digging themselves deeper into their mistaken projects . during which the economy returns to a sustainable growth path. too many projects are started. It’s still the case that if work begins on a new car factory. During the artificial boom. meaning that people who happen to be working at extremely unprofitable businesses (but which seemed profitable during the boom) need to lose their jobs once the bust occurs .
. the better. during the early stages of the boom. then those resources are “locked up” in the project for at least two years until they begin to “bear fruit” in the form of new cars . For example. if six months’ work has been done on a new car factory that will take another 18 months to complete. in light of the shocking realization that the plans made during the boom were mistaken—and in some cases. very badly mistaken . the sooner the central bank chickens out and lets interest rates return to their appropriate level. there is a period of confusion where everyone in the market needs to reevaluate his or her situation.370
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unemployed actually prolong the recession and sow the seeds for the next unsustainable boom . If. because the false interest rate is too permissive . there are real. If workers and materials are devoted to building a new car factory that will take two years to complete. physical resources involved as well . and that the process isn’t simply about money . If we step back and think about the adjustment process. now need to be redirected elsewhere . And that requirement includes labor resources.

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then obviously the correct thing to do is to stop building it immediately . In the modern united states. use tax dollars to subsidize the company that owns the factory. it’s not “compassionate” for the government to. it’s important to realize the actual function that a prolonged spell of large-scale unemployment serves . consider the construction workers who built houses in Las Vegas during the great housing boom from the early 2000s through 2006 . interests. many people would far prefer the government to step in and provide immediate relief . no. the correct response of another
. specifically? each construction worker in the Las Vegas area was a unique individual. in order to prevent the construction workers from being laid off. the central planner wouldn’t know how to make efficient use of the resources at his disposal . and to “create” jobs in the factory making cars that no one wants to buy . Clearly there were too many workers (and other resources such as lumber and nails) going into the Las Vegas housing industry during these years. the “correct” response of one worker may have been to get on a bus to texas to take a job at an oil refinery . is that it takes time for the economy to rebalance itself after an artificial boom. or construction workers. By the very same token. i . especially if the boom has lasted years . say. Consequently. where they can’t find a productive niche in the streamlined economy. and personal circumstances . for example. of course. then. For example. there could be a period of months or even longer for some of the displaced workers. with different skills. the correct thing to do is allow those workers and other resources (which can be salvaged) to flow into other projects or sectors that are actually profitable . the problem with this “tough love” recommendation. in the wake of the bust . or school teachers. and let alone how many people within each of these broad totals should live in each particular city in the united states . a would-be central planner would have no idea how many people “should” be brain surgeons.. no person or even group of experts could possibly know the “right” way for the economy to adjust. But what. Remember the critical flaw with outright central planning. From the point of view of the whole economy.e . pure socialism: Without market prices and the profit-and-loss test. and the “correct” thing to do would be for them to do something else with their labor time . Rather than waiting for the “laissez-faire medicine” to work. in light of a collapsing boom . Yet even here.

notice that all of these issues are given their due weight in the pure market economy . the longer an unemployed person searches. individuals bear the brunt of their delay in finding new work. we see that the pure market economy is the best way to solve it. that’s what it means to say the prosperity of the boom years was illusory—people really weren’t as rich as they thought . But it can shed light on the results of particular policies.372
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may have been to go back to graduate school and finish his Ph . for example. However. By establishing a system of unemployment compensation. If there were no formal government scheme for unemployment
. because his wife held a great job as a personal assistant to a successful Vegas attorney . the issue is not simply a matter of cruelty versus compassion . the drawback of longer searches is that the unemployed person isn’t contributing anything directly to the economic system. As we have stressed throughout this book. What happens then is that laid off workers begin looking for work. After the boom collapses. waiting for the housing market to recover. economic analysis per se cannot decide which government policies are good and which are bad . And perhaps the correct response of a third worker would have been to take a huge pay cut flipping burgers in Vegas. he must live off of the output of others during his search . in literature . because there are no government unemployment programs that (to put it bluntly) pay people not to find a new job . It takes time for people to search for new positions . and which doesn’t require them to move or (at least) to move to an area they detest . no government official decides where the worker “ought to go now . many workers realize that they can’t earn the same paychecks they had become accustomed to . each displaced worker is allowed the freedom to choose his or her new job. it simply redistributes them . the better his new job is likely to be . now that we have some idea of the scope of the problem. hoping to find a new job that offers a salary and other features comparable to their old job. so that citizens and government officials can make informed decisions . the government reduces the earnings of employed workers.D .” At the same time. In the case of mass unemployment. and makes it less attractive for profitable businesses to expand at the onset of the recession . the government doesn’t create resources or wealth. based on all the factors relevant to the individual.

. individuals and businesses would still have the option of using their larger paychecks and profits (which would no longer be subject to contributions to the unemployment fund) to build up their savings in order to provide a cushion during times of economic hardship . it would stop using the central bank to artificially suppress interest rates . and would in fact hurt workers (all things considered) . If the government and public could resist the urge to meddle during a recession. But once we admit that there can be such a thing as unemployment benefits that are too “generous. It is not a fact of engineering or chemistry to say how long unemployment relief should last. there would be no need for further dislocations . Finally. Perhaps this free market cushion would in practice be smaller than the duration of unemployment checks established by the government. it would clearly be wasteful if the government established a rule saying that anyone laid off from his job could collect checks equal to 95% of his former salary. For example. in practice the central bank often “cures” a recession simply by fueling the upswing of another unsustainable boom . that is clearly an economic question . but again. until he finds a new job . for up to 20 years. if the government were really interested in helping the unemployed. what economics shows us is that there is a tradeoff involved .Advanced Lesson 23: The Business Cycle
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insurance. and simply let the correct market prices redirect workers and resources to sustainable niches. even the most zealous advocates for the unemployed would admit that that hypothetical policy would be disastrous. unfortunately.” our knowledge of basic economics makes it hard to justify the government’s decision to provide benefits in excess of what would have occurred in a voluntary pure-market economy .

Government efforts to “help”—such as sending checks to people without a job—prolong the period of high unemployment. but the prosperity is an illusion. After the recession sets in. stagnant or even falling wages and corporate earnings. When the central bank creates new money and releases it into the credit markets.
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Lesson Recap •••
• The business cycle is the regular pattern in market economies where there are a few years of a “boom” characterized by low unemployment. rising wages and corporate earnings. causes the boom-bust cycle by interfering with the market interest rate. the market must reallocate them to their proper niches. and the liquidation of many businesses. • The government. acting through the central bank. many workers and other resources are channeled into the wrong industries. giving a false signal to entrepreneurs to expand their operations and invest in long-term projects. and appears as high rates of unemployment. After the boom there is a “bust” or recession. because it is not based on genuine saving but instead on inflation. People feel richer during the boom. • During an unsustainable boom (generated by inflation in the credit markets). This shuffling of workers can take time. this artificially lowers the interest rate. characterized by high unemployment. and the expansion of many businesses. The inevitable crash is actually the market’s desirable readjustment to the underlying realities.

Keynesian economists would justify government deficits during a recession as a way to stimulate total spending and to boost employment .
. “eating the seedcorn.Advanced Lesson 23: The Business Cycle
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new Terms
Business cycle / boom-bust cycle: the regular pattern in market economies where a “boom” period—characterized by low unemployment and prosperity—is followed by a “bust” or recession period— characterized by high unemployment and business failures . Capital consumption: Achieving a higher standard of living (temporarily) by failing to invest enough in the maintenance of capital goods . Countercyclical policies: standard government and Federal Reserve policies that are supposed to counteract the movements of the free market .” metaphorically speaking . Macroeconomics: the subdivision of economics that focuses on economywide issues such as price inflation and the business cycle . For example.

*How does capital consumption give the illusion that an economy can have its cake and eat it too? 5. market-driven expansion—where the interest rate falls because people are consuming less and saving more—the extra resources flowing into the new investment projects are coming from the sectors which are seeing a drop in sales.” 3.376
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sTudy QuesTions
1. How does an unsustainable boom lead to mass unemployment?
. Why is the business cycle sometimes called the boom-bust cycle? 2. *Do central banks typically lower interest rates by imposing a price ceiling (analogous to rent control)? 4. Explain: “[I]n a sustainable.

(Lesson 7) Austrian economics: A school of thought (inspired by Carl Menger and others who happened to be Austrian) that blames recessions on government interference with the economy. (Lesson 2)
Bank: A common credit intermediary. (Lesson 12)
.
(Lesson 2)
Axioms:
the starting assumptions or foundations in a deductive system . which takes deposits from many different lenders and makes loans to many different borrowers .Glossary
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Glossary
Absolute advantage: Occurs when a person can produce more units per hour in a particular task. but are assumed to be true in order to prove other. statements . For example. the method of constructing a straight line between two points could be an axiom in a geometry textbook . less obvious. Axioms are not proved. (Lesson 8) Anarchists: People who think there should be no government . and recommends tax and spending cuts to help the economy during a recession . compared to someone else . (Lesson 15) Arbitrage opportunity: the ability to earn a “sure profit” when the same good sells at different prices at the same time .

in the hopes of receiving back the principal plus interest in the future .
(Lesson 4)
Black market: the system of illegal transactions that violate government regulations . (Lesson 19) Benefits: the subjective enjoyments flowing from a course of action . which is a legally binding promise to repay borrowed money plus interest . (Lesson 18) Bond: A corporation’s IOu. 18) Business cycle / boom-bust cycle: the regular pattern in market economies where a “boom” period—characterized by low unemployment and prosperity—is followed by a “bust” or recession period— characterized by high unemployment and business failures . (Lesson 10) Budget deficits: the excess of government spending over tax receipts .378
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Bankrupt: the situation that occurs when a business has liabilities greater than its assets . (Lesson 12) Borrowing / dissaving: the amount by which consumption spending is greater than income .
(Lesson 1)
Beggar-thy-neighbor policies: Policies (usually involving currencies and trade restrictions) that make other countries poorer. rather than using money in an intermediary transaction . the buyer of a bond gives money to the corporation today. (Lessons 2. in the attempt to make one’s own country richer . the deficit is the amount the government must borrow to pay its bills in a given period .
(Lesson 23)
. (Lesson 14) Barter: A situation where people exchange goods and services directly.

Glossary
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Callable bonds: Bonds that the issuer (borrower) has the right to pay off ahead of schedule . if a borrower wants money to buy a house or a car. (Lesson 5) Collateral: An asset that a borrower “puts up” when applying for a loan . the lender may take possession of the collateral as compensation . which points out that because socialist planners lack market prices for resources. the very wealthy capitalists exercise a large degree of control over businesses . they are not direct gifts from nature . (Lesson 5) Capitalists: the people in a capitalist society who control (large amounts of) financial wealth . the lender can take control of the house or car . no single person or group controls the system as a whole . “eating the seedcorn. (Lesson 15) Capital consumption: Achieving a higher standard of living (temporarily) by failing to invest enough in the maintenance of capital goods . they would have no idea whether they were using scarce resources in an efficient way to best serve the citizens .
(Lesson 23)
Capital goods: Producer goods that are produced by human beings. meaning that if the borrower fails to make his or her payments on schedule. (For example. (Lesson 4) Capitalism: A economic system relying on private property and free enterprise . even if the planners were angels.) (Lesson 12)
. (Lesson 14) Calculation problem: the objection Ludwig von Mises raised against socialism. these items themselves can serve as the collateral. they can’t determine if a particular project uses up more resources than it produces in goods and services . If the borrower defaults.” metaphorically speaking .

in order to produce goods and services to be sold to the same customers . (Lesson 15) Communism: An economic and political ideology that seeks to gain government ownership of the means of production (in the name of the workers) through violent revolution . (Lesson 16) Comparative advantage: Occurs when a person has the relative superiority in a particular task. For example. the CPI is an
. (A reduction in the price of hot dogs will probably cause an increase in the demand for mustard . when taking all other tasks into account . according to a unified central plan . even if Mary has the absolute advantage.380
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Command economy / command-and-control economy / socialism: An institutional arrangement in which the government owns all the major resources. (Lesson 9) Complements: Goods (or services) that consumers use together . and directs labor. A change in the price of one good tends to cause a change in the opposite direction in the demand for a complement . because Mary might have an absolute advantage that’s even greater in something else . hot dogs and mustard might be complements if someone goes to the store in preparation for a cookout . (Jim can have a comparative advantage in a certain task.)
(Lesson 8)
Competition: the rivalry that exists between entrepreneurs who have the option of hiring the same workers and buying the same resources. (Lesson 4) Consumer Price Index (CPI): the Bureau of Labor statistics’ gauge of the “price level” affecting regular households .) (Lesson 11) Consumer goods and services: scarce physical items or services that directly satisfy a person’s preferences .

If there are 100. Keynesian economists would justify government deficits during a recession as a way to stimulate total spending and to boost employment . (Lesson 20) Countercyclical policies: standard government and Federal Reserve policies that are supposed to counteract the movements of the free market . knowing that they had no recourse . food. either because they are accepting bribes from drug dealers or because they themselves are trafficking in prohibited substances . and other common items .Glossary
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average (weighted by their relative importance) of the prices of gasoline.
(Lesson 12)
Credit limit: the maximum amount of money that a person can borrow from a pre-approved source (such as a credit card) . (Lesson 21)
Corporate stock: Partial ownership claims to a corporation . (Lesson 12)
. (Lesson 14) Corruption: In the context of the drug trade.000 shares owns 5% of the corporation itself . someone who buys 5. (Lesson 23) Credit card: A device that allows the borrower to achieve virtually instant loans from the credit card company when making purchases .
(Lesson 12)
Credit history: A person’s record of borrowing and repayment behavior . In some cases police officers have simply robbed drug dealers (of cash) at gunpoint.000 total shares of stock in a corporation. (Lesson 12) Credit intermediary: A person or organization that is the “middleman” between lenders and borrowers . the failure of police and other government officials to execute their duties. For example.

debasement meant melting the coins and re-minting them with baser (less valuable) metals added to the mixture . under fiat money. which makes the equilibrium interest rate higher than it otherwise would be . which helps potential lenders decide on the riskiness of lending money to the person . which reduces the value of a single unit of money . (Lesson 12) Crowding out: the reduction in private-sector investment that results from government deficit spending . When coins were valued because of their precious metal content. debasement involves the rapid creation of new money. (Lesson 12) Credit score: A number that an agency will assign to a person based on his or her credit history. At the higher interest rate. because they have not been keeping up with their required payments . (Lesson 22) Credit Transaction: An exchange where one person gives up something (such as money) today. the government’s borrowing increases the demand for loanable funds. while the other person promises to give up something (such as money) in the future . (Lesson 12)
Debasement: Government policies that weaken the money .382
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Credit risk: the likelihood that a borrower will be unable to pay back a loan . (Lesson 12)
. (Lesson 21) Default: A situation when a borrower stops making repayments on a loan . private-sector businesses borrow less to fund investment spending .
(Lesson 12)
Delinquencies: Cases where borrowers are not in good standing with the lender (such as a bank).

People only engage in labor because of its indirect rewards . sometimes a generic demand curve is drawn as a smooth.” meaning that they start in the upper left and move down and to the right . (Lesson 6) Discount: the percentage by which the value of a unit of money is reduced.
(Lesson 12)
Disequilibrium: An unstable situation in which at least two people stand to benefit from an additional trade . (Lesson 11) Demand schedule: A table that illustrates the demand relationship either for an individual or a group .Glossary
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Demand: the relationship between the price of a good (or service). curved line or even as a simple straight line . with price placed on the vertical axis and quantity on the horizontal axis . (Lesson 11) Demand curve: A graphical illustration of the demand relationship. because it will not be received until the future . and the number of units that consumers want to purchase at each hypothetical price . (Lesson 6) Disutility of labor: economists’ term to describe the fact that people prefer leisure to labor . (Lesson 4)
. (Lesson 12) Depreciation: the wearing away or “using up” of capital goods during the course of production . Demand curves are “downward sloping. (Lesson 4) Direct exchange / barter: trading that occurs when people swap goods that they directly value . (Lesson 11) Depositors: People who give their money to a bank .

(Lesson 8) Economize: the act of treating a resource with care because it is scarce and can only satisfy a limited number of goals or preferences . (Lesson 20)
Economic democracy: An analogy to politics often used by (democratic) socialists to justify socialism . one vote” system . (Lesson 13) Economies of scale: A condition in which output will increase more than proportionally as inputs are increased . For example. but would instead prefer a democratic “one person. and then trades to obtain the things produced by others . (Lesson 14) Division of labor / specialization: the situation where each person works on one or a few tasks. there are economies of scale if doubling the amount of inputs leads to a tripling in output .384
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Dividend: A disbursement of a portion of a corporation’s net earnings to the stockholders . Most people would not like an aristocratic system in which a few elites made all the political decisions. (Lesson 8) Drug prohibition: severe penalties that the government imposes on the consumption and especially the production and sale of certain drugs .
(Lesson 4)
. (Lesson 15) Economic problem: How to allocate society’s scarce resources (including labor) in order to produce the combination of goods and services that best satisfies people’s preferences . the socialists argue that their program simply applies this logic to the economic arena. taking power away from the small group of wealthy capitalists and showering it on the masses .

and other inputs during a period of time . the equilibrium price occurs at the intersection of the supply and demand curves . (Lesson 4) Equilibrium position: A stable situation in which there are no further gains from trade . at the equilibrium price . and consumers want to buy. (Lesson 11) Exchange rate: the “price” of one currency in terms of another. which involve his or her understanding of “how the world works” and therefore guide current actions .Glossary
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Entrepreneur: the person in a market economy who hires workers and buys resources in order to produce goods and services . On a graph. (Lesson 19)
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(Lesson 9)
Equilibrium: A stable situation after all disturbances or changes have worked themselves out . or how many units of one currency will trade for one unit of another currency . (Lesson 6) Equilibrium price / market-clearing price: the price at which producers want to sell exactly the number of units that consumers want to purchase . (Lesson 11) Equilibrium quantity: the number of units that producers want to sell. (Lesson 12) Expectations: An individual’s forecasts of the future. (Lesson 9) Exports: Goods (and services) that the people of a country sell to foreigners . On a graph. raw materials. the equilibrium quantity occurs at the intersection of the supply and demand curves . (Lesson 4) Expenses: The amount of money an entrepreneur spends on labor.

the flow rate of an irrigation pipe could be 100 gallons per minute . than the bank has cash in the vault .386
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Face value of a bond: the amount of money the bond issuer promises to pay to the holder of the bond at the maturity date . (Lesson 12)
. is that they expect it to have purchasing power in the future . founded in 1913 . (Lesson 21) Fixed costs: Monetary expenses that do not increase when a business expands output . (Lesson 16) Federal Reserve: the central bank of the united states. (Lesson 22) Fractional Reserve Banking: the typical practice where banks do not keep all of their customers' deposits in the vault . In other words. For example. For example. monetary policy. and has the dual mandate of providing stable economic growth (which implies full employment) and low price inflation .s . and so this is a fixed cost . (Lesson 22) Fascism: An economic and political ideology that also seeks extensive government regulation of all resources in the service of the collective good. a barber shop’s monthly water bill will be roughly the same whether it provides 1 haircut or 100 haircuts per day. the only reason people accept fiat money in trade. (Lesson 21) Fiat money: Paper money that is not “backed” by anything . this measurement wouldn’t refer to the total amount of gallons contained in the entire pipe. though fascism (unlike communism) allows private individuals to officially retain ownership of the factories and other capital goods . the “Fed” is responsible for u . but instead would refer to how many gallons passed through a particular section of the pipe every 60 seconds . all of the bank's customers have more money on deposit. (Lesson 20) Flow variable: A concept that is measured over a period of time .

(Lesson 5) Free trade: An environment in which governments do not impose artificial restrictions on the flow of goods and services between their citizens and foreigners . (Lesson 13) Guilds: the organization of occupations in the medieval period. (Lesson 14) Goods: scarce physical items that an individual values because they can help to satisfy his preferences . this is what newspapers mean when they report on a corporation's “profits” for a given time period . A person who wanted to become a blacksmith or a carpenter would first need to be accepted by other members of the guild . (Lesson 6) Going public: Allowing the general public to buy shares of stock in a corporation. as opposed to restricting ownership to those specifically invited by the owners .Glossary
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Free enterprise: A system in which individuals can choose their own occupations and are free to start whatever business they wish . (Lesson 18) Gross profit / accounting profit: the excess of revenues over out-of-pocket expenses . (Lesson 19)
Gains from trade: A situation in which two people can both gain (subjective) benefits from swapping their property with each other . before the capitalist era . they don’t need special permission from anyone to enter an industry . (Lesson 3) Graduated income tax: An income tax that applies higher rates to higher levels of income . (Lesson 5)
.

there is no precise boundary between inflation and hyperinflation. Income taxes are usually applied as percentages of the pre-tax dollar income . but in a hyperinflation people begin buying anything at all in order to unload their money holdings which are losing value by the hour . which is taxed at 3%. (Lesson 4) Income / earnings (business): Revenues minus expenses . (Lesson 10) Income tax: A tax that applies to the earnings of an individual or a corporation . (Lesson 21)
Import quota: A maximum limit on the amount of a particular good that can be imported during a certain time period . (Lesson 10) Income (individual): the amount of money that can be spent on consumption goods in a certain period. (Lesson 19) Income: the flow of consumer goods and services that a person has the potential to enjoy during a specific period of time . from the sale of labor and the earnings of other assets (such as stocks) . the lowest tax bracket might include incomes ranging from $0 to $10.388
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Hazard pay: the higher earnings necessary to attract workers into an industry that is more dangerous than others .
. (Lesson 19) Imports: Goods (and services) that the people of a country buy from foreigners . For example.000. (Lesson 18) Income Tax Brackets: the thresholds of income that are taxed at various rates . (Lesson 20) Hyperinflation: Very severe inflation .

(Lesson 14) Interventionism: the philosophy of the mixed economy. (Lesson 14) Indirect exchange: trading that occurs when at least one of the parties accepts an item that he or she does not intend to use personally.001 to $20.000. (Lesson 18)
Incorporation: transforming a business into a corporation. so that its ownership is allotted by shares of stock . and the interest rate is 5% . For example.050 twelve months later. (Lesson 10) Interest rate risk: the risk bondholders face because rising interest rates will reduce the market value of their bonds . Institutions provide a framework of predictability in society . the interest earned is $50.Glossary
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while the next bracket might include incomes ranging from $10. but nowadays often means an increase in prices . which is taxed at 5% . (Lesson 6) Inflation: A term that originally referred to the creation of new money. (Lesson 5) Interest: the income earned during a period of time from lending savings to others . then the principal is $1. but instead will trade it away in the future to get something else . Interest is usually quoted as a percentage of the principal (the amount of money originally lent) earned per year . 21) Initial public offering (IPO): the auction of shares to the general public when a corporation first decides to go public . in which the government heavily intervenes in the capitalist system to
.000. (Lessons 18.000 today and is paid back $1. (Lesson 14) Institutions: social relationships and practices that allow people to interact with each other . if someone lends $1.

(Lesson 11) Law of Supply: If other influences stay the same. (Lesson 11)
. (Lesson 14) Issuing stock / issuing equity: Raising funds by selling stock shares to investors .390
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regulate how individuals can use their private property . 10) Issuing debt: Raising funds by selling bonds to lenders . while a higher price will lead them to buy fewer units . then a lower price will lead consumers to buy more units of a good (or service). while a lower price will lead producers to sell fewer units . (Lesson 14)
Keynesian economics: A school of thought (inspired by John Maynard Keynes) that prescribes government budget deficits as a way to lift the economy out of recession and restore full employment . (Lessons 4.
(Lesson 17)
Investment: Diverting resources or savings into projects that are expected to increase future income .
(Lesson 4)
Law of Demand: If other influences stay the same.
(Lesson 4)
Land / natural resources: Factors of production that are gifts of nature . then a higher price will lead producers to sell more units of a good (or service).
(Lesson 2)
Labor: the contribution to production flowing from a person’s body .

(Lesson 2)
M1: A popular measure of the total amount of money in an economy . If everyone tried to withdraw his or her checking account from the banks at the same time. (Because of the fractional reserve banking system. this is why M1 indicates more total money than just the amount of paper currency . M1 includes the actual currency held by the public (in their wallets. (Lesson 14) Loan sharking: the practice of lending money at high interest rates and using illegal methods to obtain repayment .) (Lesson 21) Macroeconomics: the subdivision of economics that focuses on economywide issues such as price inflation and the business cycle . purses.
(Lesson 23)
. (Lesson 12) Logical deduction: A form of reasoning that starts from one or more axioms and moves step-by-step to reach a conclusion .Glossary
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Leisure: A special type of consumer good that results from using one’s body (and time) to directly satisfy preferences. there wouldn’t be enough currency to go around . M1 is larger than the number of dollars printed on green pieces of paper . (Lesson 4) Leverage: enhancing the potential returns from an investment by using borrowed money . and cashiers’ drawers) but also the total amount of checking account balances . (Lesson 20) Loanable funds market: the market in which lenders give money to borrowers at an agreed-upon interest rate . as opposed to engaging in labor .

(Lesson 17) Mixed economy: A system that allows private citizens to legally own resources. (Lesson 5)
. but it can also be water if you are in a pool with your head below the surface . When it comes to sound waves. and the interest rate that applies to it . (Likewise. but because he or she wants to trade it away in the future to acquire something else. but in which government officials lay down rules that limit the choices the legal owners can make with their property .) (Lesson 12) Medium of exchange: An object that is accepted in a trade. Every indirect exchange requires a medium of exchange.) (Lesson 7)
Mercantilism: the economic doctrine that views the accumulation of wealth as the path to national prosperity . (Lesson 19) Minimum wage: A price floor on payments to workers . (Lesson 5) Maturity: the time duration of a specific loan.392
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Marginal productivity: the increased revenues that result from hiring an extra worker . sound waves require a medium to travel through. (Lesson 9) Marginal utility: A technical economics term referring to the subjective enjoyments of one additional unit of a good or service . It encourages exports and discourages imports . in order to reach your ears . not because the
person receiving it wants to directly use it. the medium will usually be the air.
(Lesson 4)
Market economy: Can be a synonym for capitalism . (Loans and their corresponding bonds can have shorter or longer maturities . It also refers to the collection of voluntary exchanges that occur in a capitalist system . which is the good through which the ultimate trade occurs .

(see http://www . usually the property serves as collateral for the mortgage . but much of this consists of treasury bonds held by other government agencies (such as the social security Administration’s “trust fund”) . (Lessons 6. As of May 2010.s . it is a widely (or universally) accepted medium of exchange . they usually net out the “intragovernmental holdings” and report only the government debt held by the public.
(Lesson 9)
Money: A good that is accepted by everyone in the economy on one side of every trade .5 trillion .pdf . (Lesson 9) Monetary loss: the amount by which expenses are greater than revenues .s . this figure for the u . the “public debt” was almost $13 trillion. (Lesson 21) Monetary profit: the amount by which revenues are greater than expenses . As of May 2010.gov/ govt/reports/pd/mspd/2010/opds052010 . (Lesson 13)
. 7) Mortgage: A special type of loan in which the borrower buys a house (or other real estate) with the funds .) (Lesson 22) Net profit / economic profit: the portion of gross profits over and above the normal interest return on the invested capital . treasury .treasurydirect . In economics jargon.Glossary
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Monetary inflation: An expansion in the total amount of money in the economy . When economists compare the levels of debt owed by various governments. treasury was almost $8 . (Lesson 12)
National debt / public debt: usually refers to the total outstanding value of bonds issued by the u .

the owner can usually transfer ownership to another person . (Lesson 5)
Paternalism: Overriding the desires of someone else because he or she is not considered competent to make the right decision . (Lesson 4) Owner: the person who has legal authority to decide how a particular unit of a resource or good shall be used .
(Lesson 17)
Price controls: Policies that punish people who exchange goods and services at prices different from the acceptable range prescribed by the government . quoted in units money .394
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(Opportunity) cost: the benefits of the next-best alternative to a given action . (Lesson 18) Preferences: An individual’s goals or desires . Price inflation is the same thing as a fall in the purchasing power of money .
(Lesson 3)
Price: the terms of a trade. economists interpret a person’s actions as attempts to satisfy his or her preferences . (Lesson 6) Price ceiling: A type of price control on a particular good or service that sets a maximum level on the amount a buyer can pay a seller . (Lesson 17) Price inflation: A general increase in the prices of goods and services. meaning how many units of one item are given up to acquire a unit of a different item . (Lesson 21)
. (Lesson 17) Price floor: A type of price control on a particular good or service that sets a minimum level that a buyer must pay a seller .

Glossary
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Price supports: Government policies that maintain a desired minimum price not by threatening buyers who pay too little. (Lesson 4) Productive debt: Debt used to finance investments . Ideally.) (Lesson 17) Private property: A system in which resources are owned by people outside of the government . (Lesson 5) Private sector: the portion of an economy that is controlled by people outside of the government . a grocery store is in the private sector . (Lesson 8) Progressive income taxation: A system that taxes individuals or corporations at higher rates based on the level of income . (Lesson 4) Productivity of labor: the amount of output a worker can produce in a certain period of time . (the effects of price supports are different from the effects of price floors . because they can be used to produce consumer goods and services . often used in reference to labor . (For example.
(Lesson 3)
. the extra income from the investment spending will allow the borrower to make the interest payments resulting from the increase in debt.) (Lesson 5) Producer goods / factors of production / means of production: scarce physical items or services that indirectly satisfy preferences. but instead by having the government directly buy the good or service whenever its market price would otherwise fall below the floor . so that the extra borrowing “pays for itself .” (Lesson 12) Productivity: the amount of output produced by a factor of production in a period of time.

(Lesson 19) Public sector: the portion of an economy that is controlled by the government .) (Lesson 11)
. behavior that has a goal .
(Lesson 14)
Reduction in demand / leftward shift in the demand curve: A situation in which a change besides the price of a good (or service) causes consumers to reduce the number of units they want to purchase. the government will encourage consumers to “buy local. (Lesson 2)
Raise capital: the process of obtaining funds for a growing business by selling partial ownership of the business to outside investors . On a graph. On a graph. (For example. (Lesson 11) Reduction in supply / leftward shift in the supply curve: A situation in which a change besides the price of a good (or service) causes producers to reduce the number of units they want to sell.396
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Protectionism: the philosophy that uses government trade restrictions in an attempt to help workers within the home country . an increase in supply or a rightward shift in the supply curve. the local police station is in the public sector .” providing employment for local workers . the rationale is that by restricting foreign imports. at various possible prices .) (Lesson 5) Purposeful action: An activity undertaken for a conscious reason. at various possible prices . this change causes the supply curve itself to move to the left . at various possible prices . (In a similar way. occurs when a change causes producers to increase the number of units they want to sell. this change causes the demand curve itself to move to the left .

(Lesson 14) Rent control: A price ceiling placed on apartment rents .Glossary
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Refinancing (a mortgage): the situation that occurs when a homeowner gets a new mortgage from the bank (perhaps at a lower interest rate or with lower monthly payments) and uses it to pay off the current mortgage . (Lesson 1)
. sales taxes are usually applied as percentages of the pre-tax dollar amount . (Lesson 14)
Sales tax: A tax that applies to goods and services as they are sold to the customer . (Lesson 18) Saving: Consuming less than one’s income would allow. scarcity is a universal fact requiring people to make exchanges . (Lesson 9) Rolling over debt: Paying off an old set of bondholders by issuing new bonds . (Lesson 17) Residual claimants: Refers to stockholders. living below one’s means . who are entitled to the earnings of a corporation only after the other creditors have first been paid . (Lesson 4) Savings: the amount by which income is greater than spending on consumption . (Lesson 14) Revenues: the amount of money customers spend on an entrepreneur’s output during a period of time . (Lesson 10) Scarcity: the condition of desires exceeding the available resources to satisfy them .

the person eventually must buy back the asset to return it to the original owner . services are the “goods” that people create through their labor power . (Lesson 15) Short sale: A transaction in which a person borrows an asset (such as a share of stock) from an existing owner. (Lesson 12) Shirking: Deliberately working less than one’s potential . in order to sell it at the current price . the advantage to the borrower is that the interest rate is lower than it would be for a comparable unsecured loan .
(Lesson 20)
Slavery: A system in which some human beings are considered the legal property of others . but also to encourage people to reduce their purchases of these dubious items . (Lesson 5) Slumlord: the unflattering term applied to a landlord who doesn’t maintain the quality of the apartments and who is generally unscrupulous . (Lesson 14) Shortage: A situation where consumers want to buy more units than producers want to sell . car. etc . in case the borrower defaults . (Lesson 11) Sin taxes: High sales taxes on goods such as cigarettes and liquor that are imposed not merely to raise revenue.) pledged as collateral. this occurs when the actual price is below the market-clearing price .398
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Service: A person’s performance of a task that another person values because it helps to satisfy preferences . (Lesson 3) Secured loan: A loan that has an asset (such as a house. (Lesson 17)
.

(Lesson 12) Stock brokerages: Companies that help individuals buy and sell stocks . the most famous example is the new York stock exchange. (Lesson 14) Stock of money: the total amount of money in the economy at a particular time . A positive spread allows the credit intermediary to earn income from its activities. the broker will act on behalf of the client and execute his or her orders to buy and sell shares .Glossary
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Socialism: An economic system in which government officials decide how society’s resources shall be used to produce particular goods and services . compared to the interest rate it pays to its lenders or depositors . so long as it has correctly estimated the likelihood of default by its borrowers . (Lesson 14) Stock exchanges: Particular locations or venues where stocks are traded . the style of clothing that characterized the 1970s disco clubs. examples would include the rules of grammar in the english language. (Lesson 5) Sole proprietorship: A business owned by a single person . located on Wall street . (Lesson 7) Spread: the difference between the interest rate that a credit intermediary (such as a bank) earns from its borrowers. and the use of money . or who sells an asset thinking its price will fall . (Lesson 21)
. (Lesson 14) Spontaneous order: A predictable pattern that is not planned by any one person . (Lesson 14) Speculator: A person who buys an asset (such as a corporate stock) thinking its price will rise.

(Lesson 22) Subjective: unique to each individual. with price placed on the vertical axis and quantity on the horizontal axis . (Lesson 11) Supply schedule: A table illustrating the supply relationship.m . this measurement wouldn’t refer to the number of pounds the man had recently gained or lost.” meaning that they start in the bottom left and move up and to the right . Coke and Pepsi might be substitutes if someone goes to the store looking to buy soda . and the number of units that producers want to sell at each hypothetical price . curved line or even as a simple straight line .”
(Lesson 3)
Substitutes: Goods (or services) that consumers use for similar purposes . 2010 could be 150 pounds . A change in the price of one good tends to cause a change in the same direction in the demand for a substitute . (Lesson 11)
. but instead would refer to his weight at that very moment .400
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Stock market: A special type of market in which buyers and sellers exchange shares of corporate stock . (A reduction in the price of Coke will probably cause a reduction in the demand for Pepsi .) (Lesson 11) Supply: the relationship between the price of a good (or service). supply curves are “upward sloping. either for an individual or group of producers . “in the eye of the beholder . For example. sometimes a generic supply curve is drawn as a smooth. a man’s weight at 9 a . For example. on May 11. (Lesson 14) Stock variable: A concept that is measured at a specific point in time . (Lesson 11) Supply curve: A graphical illustration of the supply relationship.

a gauge of people’s impatience to receive enjoyments . (Lesson 19)
. (Lesson 19) Trade surplus: the amount by which exports exceed imports.
(Lesson 18)
Taxation: the process in which the government takes ownership of portions of income or other assets from private individuals . (Lesson 19) Tax Deduction: A provision in the tax code that allows a particular expense (such as medical expenses or the purchase price of a new solar panel) to be subtracted from an individual’s taxable income . measured in money . this occurs when the actual price is higher than the market-clearing price . (Lesson 12) Trade deficit: the amount by which imports exceed imports. (Lesson 18) Taxable income: the amount of income actually subject to the official tax rates for each bracket . taxable income is the original income after all deductions and other adjustments have been made .” which allows an individual to buy more with his income .Glossary
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Surplus / glut: A situation where producers want to sell more units of a good (or service) than consumers want to purchase . (Lesson 11)
Tariff (duty): A tax levied on foreign imports . measured in money .
(Lesson 18)
Time preference: the degree to which people prefer to consume sooner rather than later. this means that tax-deductible items are paid for with “pretax dollars.

there are winners and losers . mutually advantageous. (Lesson 19)
. the lender has no other options .402
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Tradeoffs: the unfortunate fact (caused by scarcity) that making one choice means that other choices become unavailable . meaning that some workers cannot find jobs even though they are willing to work for the same pay and can perform the jobs just as well as the people who are employed . If the borrower defaults. (Lesson 20) Utility: A term common in economics textbooks to describe how much value a person gets from a good or service . (Lesson 17) Unsecured loan: A loan that has no collateral serving as a backup .
(Lesson 12)
Usury laws: Price ceilings on interest rates . (Lesson 3)
Zero-sum game: A situation in which the gain of one person (or country) corresponds to an equal loss of another person (or country) . the advantage to the borrower is that none of his or her other assets can be seized (or “repossessed”) in the case of default . (Lesson 1)
Unemployment: A surplus or glut on the labor market. In a zero-sum game. win-win outcomes are not possible .